The ETF: What is it?
An Introduction to Investment Planning – Part 5.5
For decades the mutual fund has dominated the investment world of the average Canadian. You could walk into your local bank or credit union, get a recommendation from your friendly financial advisor, invest as little as $100, set up pre-authorized withdrawals from your chequing account for additional investments each pay period, and everything was all taken care of. That convenience is a good thing because it makes it easy to set aside money for your retirement in your RRSP and/or your TFSA.
Mutual funds still dominate the Canadian investing world but more recently, the Exchange-Traded Fund (ETF) has gained greater attention and captured a greater share of the investment market.
What is an ETF?
First, mutual funds and ETFs are, as the respective names make clear, both funds. You may think of funds as a synonym for money. As in, “I don’t have enough funds to afford a new car.” In the case we are talking about today, an investment fund refers to a collection of securities, whether that collection is made up of a group of stocks, a group of bonds, or some combination.
My previous posting discussed various mutual fund categories. Canadian ETFs operate under the same categories. Many Canadians also invest in US-domiciled ETFs because they have US dollars available, but the categories used follow a different classification standard than in Canada. For the purposes of this article, however, that is not a matter of concern.
As the name implies, Exchange-Traded Funds trade on an exchange. In the case of the standard open-end mutual funds that we are most familiar with, investors don’t trade with other investors when we buy and sell mutual funds. Instead we are buying and selling directly with the mutual fund company. From the perspective of the mutual fund company, the units of the fund are in a constant state of issuance and redemption. These funds only have one price, the closing price on each business day, referred to as the Net Asset Value (NAV). The NAV is the net value of a mutual fund after the value of the fund’s liabilities are subtracted from its assets.
Since Exchange-Traded Funds are bought and sold on an exchange, you are buying and selling with another party on the exchange. As is the case with an any exchange-traded investment vehicle, the price moves about in the course of the day depending on the value of the underlying investments. ETFs also have a NAV but despite the push and pull of purchases and sales, the market price on the exchange generally does not deviate from the NAV.
The Role of the Market Maker
A Market Maker, also known as a Designated Broker, is usually a major securities dealer. The Market Maker will deliver to the ETF provider a basket of the underlying securities in return for a block of units (shares) of the ETF with the same market value. That is how ETF units are created. These ETFs represent inventory that can be sold on the exchange. This process can be reversed, too, with the Market Maker redeeming ETF units in exchange for the underlying basket of securities. This process of creation and redemption maintains the market price of the ETF very close to the NAV of the underlying securities.
This is an issue in mutual funds as well, but the process of creating and redeeming ETFs comes with expenses. These expenses contribute to tracking error, that is, the difference between the price of the underlying assets and the price of the ETF. Imagine if an ETF had as its underlying assets the top 100 (by market capitalization) stocks in Canada. Over the course of 2019, the underlying assets in the fund gained 21 percent, yet the ETF that you owned for the full year only gained 20 percent. That difference is tracking error.
In addition to the costs of managing the fund, tracking error can happen for two other main reasons. One is particularly common in the case of ETFs that invest in securities from overseas. There is a 14-hour difference in the time zones between Tokyo, Japan and Toronto. When ETFs are being bought in Canada, the price they are being traded at here can be different from what the closing price was in Japan. The price the ETF is trading at, then, is also impacted by news or market trends that have developed after the Japanese markets have closed.
A second impact on ETF pricing has to do with the liquidity of the underlying investments. If the ETF consists of stocks that are not easily bought and sold in the markets, there may be additional costs to create and redeem the fund, resulting in higher management expenses and a wider bid-ask spread.
When a mutual fund is bought or sold, you do not know what price you are going to get. You must place your order BEFORE the market closes, but you won’t know what the closing price will be until the NAV had been determined AFTER the market closes. In the case of ETFs, which trade throughout market hours, there are two prices. One is the bid, which is the best price a potential buyer is willing to pay in order to buy units of a particular ETF at that moment. The other is the ask, which is the best price a potential seller is willing to accept in order to sell units of that ETF.
For example, XIU is the largest Canadian Equity ETF in Canada, with over 9.2 billion dollars in assets. By contrast, DRFE is one of the newest and smallest Emerging Markets Equity ETF in Canada with less than 10 million dollars in assets. As I write this, the bid-ask spread for XIU is $25.68 – $25.69, while that for DRFE is $19.64 – $19.70. XIU is made up of the largest and most liquid stocks in Canada, while DRFE is made up of stocks from the so-called Emerging Markets (in contrast to the developed markets of western Europe, Australia, New Zealand, and Japan) around the world. Stocks from emerging markets have significant growth potential but they may be quite small, relatively illiquid and trade during hours when Canadian markets are closed.
The spread may seem like a big deal, but if you are buying for the long term, it should have little impact for you.
Management Expense Ratio (MER)
The MER represents the costs that are deducted from the value of the ETF for all the management expenses associated with the fund, including the creation and redemption process. These costs are typically much lower in the world of ETFs than they are for standard mutual funds, but that is not always the case. A variety of factors influence the MER, but broadly speaking, all other things being equal, the lower the MER the better the relative performance.
A cost to consider that is not generally found in mutual funds, or at least, not in the same way, is the trading commission. There are a couple of discount brokerages that will allow you to buy ETFs without commission, but for most brokerages, you are going to pay a commission. At the discount level, this is typically in the $7 – $10 range per trade. Full-service brokers may use a different structure in charging you for their services.
My next post will continue with a discussion of the pros and cons of ETFs versus mutual funds.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.