The ABCs of ETFs

Many investors are looking for diversified exposure to global markets. One solution is an actively managed mutual fund, in which a portfolio manager analyzes and selects individual securities (tradable financial assets like stocks or bonds) within a specific area of the market. Another option is a passively managed exchange-traded fund (ETF) that tracks an index representing a specific area of the market.

Recently, innovative solutions have emerged that combine some of the benefits, and help avoid some of the disadvantages, of each of these approaches. They’re ETFs that incorporate elements of active management, and they have the potential to deliver market-beating growth within a lower-cost ETF structure.

What is an ETF?

First, let’s take a step back and look at how a traditional, passively managed ETF works. ETFs were originally created to track indexes, which are statistical measures of change within the markets. So, for example,   an ETF may hold a basket of securities that matches – and is regularly rebalanced to keep matching – the securities in the S&P/TSX Composite Index. These ETFs offer exposure to a well-defined market – in this case, Canadian equities. Their aim is not to outperform, but to deliver the same performance as the index, minus fees. Passively managed ETFs have low operational costs and don’t require a lot of daily involvement by portfolio managers, so the fees charged are usually low.

A passively managed ETF may hold stocks, bonds, commodities, currencies, options or a blend of assets, depending on which index it is tracking. It’s easy to buy and sell, since it trades on an exchange just like a stock. It’s priced throughout the trading day, rather than only at the end of the trading day like a mutual fund. It can operate tax-efficiently because it’s mirroring an index, and indexes don’t change their composition very frequently. That means low turnover in the ETF, and fewer realized capital gains. It’s also very transparent, with portfolio holdings available daily; in contrast, mutual funds may report their holdings monthly or quarterly.

It is important to reiterate, however, that a passively managed ETF doesn’t attempt to beat market returns; its goal is simply to replicate them (minus a fee). In addition, indexes can get skewed towards companies trading at high (sometimes inflated) prices, and a passive approach can’t correct for this.

Adding a dash (or more) of active management

Newer ETFs aim to outperform market returns and/or reduce risk, focusing on one of two strategies to achieve this:

• Strategic beta ETFs apply a set of rules, or factors, that may favour a specific type of security – for example, value, growth or low-volatility stocks; as a result, the weightings of securities in a strategic beta ETF portfolio may be quite different from the index
• Actively managed ETFs have a portfolio management team that selects individual securities, just like an actively managed mutual fund, but are structured as ETFs to take advantage of ETF features such as tax-efficiency and pricing throughout the trading day

Both of these ETF types give investors access to active portfolio management insights. It’s worth keeping in mind that strategic beta ETFs – even those that use complex, multifactor approaches – often have lower management fees than actively managed ETFs. That’s because they’re more rules-based, with fewer day-to-day decisions being made by a portfolio management team.

Who can benefit from ETFs?

Because the universe of ETFs is so wide, with passively managed, strategic beta and actively managed options available, they can play many different roles in an investment portfolio. A broad-based ETF is designed to give an investor exposure to an entire market, and like a broad-based mutual fund, may form the foundation of a portfolio. More specialized ETFs, like more specialized mutual funds, can serve to add targeted exposure to specific areas of the market.

Similarly, passively managed and more actively managed ETFs can help investors achieve different goals. Passive ETFs provide exposure to market returns, while strategic beta and active ETFs may seek to deliver market-beating performance and can help achieve goals such as reducing risk in a portfolio.

In general, ETFs of all types appeal to investors who are seeking:

• Diversification
• Lower fees
• Tax-efficiency
• Transparency

Keep in mind that the advantage of lower fees is amplified over time, so investors with a longer time horizon are in the best position to benefit from it.

Speak to your advisor about whether ETFs are a good fit for your financial goals. If they are, discuss the various choices to determine the type (or mix of types) of ETF that are most appropriate for you.

What are ETFs?