ETF 101: A guide for beginners

Learn how exchange-traded funds work, what their costs and benefits are, and what to look for in them

ETF 101: A guide for beginners

Exchange-traded funds (ETFs) have grown in popularity in recent years, with assets globally of $7.65 trillion (US$5.74 trillion), according to ETFGI. In Canada, there are more than 700 ETFs listed, comprising over $185 billion in assets under management (AUM), according to the Canadian ETF Association (CETFA).

How do ETFs work?
ETFs work like mutual funds except that they are listed, bought and sold on a regulated stock exchange, typically through a broker or brokerage platform. ETFs offer the opportunity to invest in a portfolio of securities that provide the same diversification benefits of mutual funds with the trading flexibility of stocks.

ETFs exist in both the primary and secondary markets.

Participants in the primary market – ETF sponsors, dealers and market makers – create ETFs to trade on a stock exchange. When dealers buy ETF units, they typically give the ETF sponsor quantities of securities that are part of the index the ETF seeks to track. Likewise, when these institutions redeem their ETF units, the ETF sponsor provides them with securities. Through these in-kind creation and redemption techniques, the ETF incurs minimal transaction costs and does not realize capital gains.

Once dealers create ETF units, they sell them to individual investors in the secondary market – the stock exchange. Currently, investors and financial advisors need to trade ETFs through a brokerage firm or discount brokerage account. ETFs can be bought and sold at the current market price whenever the stock exchange is open. Prices typically reflect the approximate value of an ETF’s underlying securities at any given point in the day, according to Vanguard.

How is the price of an ETF determined?
Here are the costs associated with investing in ETFs, according to Horizons ETFs:

Management fee: It is the amount paid to the ETF manager that is expressed as a percentage of the fund’s average assets for the year. Management fees for large-cap Canadian index ETFs, for instance, tend to range from 0.03% to 0.1% for the more widely followed products.

Management expense ratio: MER includes the management fee plus the fund’s day-to-day operating expenses, such as record keeping, fund valuation costs, audit and legal fees. It also includes sales taxes.

Trading expense ratio: MER does not include portfolio costs, which are identified separately as TER. ETF providers typically do not showcase this expense in marketing documents because it varies based on certain factors. It may sometimes be smaller or larger than the actual management fee.

Tracking error: It is the difference between the returns of an index ETF and the index it tracks. If an ETF has a large tracking error, it may suggest that the ETF has potentially significant replication issues. Factors that impact tracking error are numerous and can usually be attributed to the expense of managing the fund, namely MER and TER.

Distributions paid by index constituents can also play a role in tracking error, as most ETFs do not reinvest distributions but instead pay those distributions to end unitholders, while most indices automatically reinvest. This loss of compounding can create tracking error, and the treatment of cash distributions can have real tax implications for some investors.

Bid-ask spread: It is the difference between the bid price and the ask price being quoted on an ETF. The wider this spread, the more an investor is paying to execute the trade on the ETF vs. the actual net asset value of the units being bought or sold.

Bid-ask spreads are tricky because they are usually a function of the ETF’s underlying liquidity. On an asset class like large-cap Canadian equities, the spread is usually no more than $0.02 per unit. However, on a less liquid asset class like foreign equities or foreign fixed income, it could be about $0.10 per unit. Thus, it is important to compare the bid-ask spread on ETFs investing in the same types of securities to determine if the cost of the ETF execution is high relative to other ETFs.

Taxes: Every investor’s tax situation is different. Different ETF structures exist to mitigate the impact of taxes.

Why buy an ETF
There are five key reasons people invest in ETFs, according to

Diversification: Buying an ETF unit means investing in a portfolio that holds many different stocks. The diversification it brings may help smooth out the ups and downs of investing using just one investment. To diversify further, investors can spread their money among ETFs that cover different investment types, such as bonds or commodities.

Passive management: Most ETFs are designed to track an index, which can be considered passive investing. Compared to active investing, passive investing tends to cost investors less. Passive strategies can outperform active strategies based on cost savings alone.

Transparency: Most ETFs publish their holdings every day, enabling investors to find out what investments their ETF holds, their relative weighting in the fund, and if the fund has changed its position in any particular investment. This transparency can help them tell if an ETF meets its investment objectives. Also, because ETFs trade on an exchange, their current market price can be easily determined.

Ease of buying and selling: ETFs can be bought and sold from an investment firm or online brokerage at any time when the stock exchange is open at the current market price at the time of the transaction.

Low cost to own: Owning an ETF costs less than a mutual fund. For instance, while actively managed and leveraged ETFs have higher MERs than index ETFs, they may have lower MERs than actively managed mutual funds.

What to look for in an ETF
Here are the most important factors to consider, according to Benzinga:

Low costs: Controlling costs should be the number one goal of ETF investors. They should keep an eye not only on expense ratios but also on how they will be taxed in their gains and dividends. It is better to pay as little as possible to management.

Tradability: When dealing with small funds, investors should make sure that there is enough liquidity to facilitate trading. Funds without strong asset bases have closure risk and often trade only a handful of shares per day. Investors should also pay attention to the AUM and average daily share volume of ETFs.

High concentration of Canadian firms: Investors should always check the holdings of their ETFs and make sure that those funds are investing in the securities they claim.