Exchange Traded Funds (ETFs) are investment vehicles that combine some of the features of Mutual Funds with some of the features of individual stocks. Although they are structured and regulated like Mutual Funds, they are listed and traded on stock exchanges similar to stocks.   ETFs are open-ended funds, which means additional units are generated and sold to meet consumer demand. In addition, they can be more tax efficient than regular mutual funds due to their low trading volumes.

The world’s first ETF was launched in Canada on the Toronto Stock Exchange in 1990.   The Toronto 35 Index Participation Units (TIPs) continues to be traded today under the ticker symbol XIU, but is now known as the iShares S&P/TSX 60 Index ETF.

There are three main types of ETFs:

Standard (index-based) ETFs replicate an index by creating a duplicate portfolio of the underlying stocks that are held on an exchange, matching their weightings exactly. So, if you purchased a TSX ETF you would be investing in all of the stocks traded on the TSX; in the amounts that they are represented on the exchange. Typically, the holdings of a standard ETF and their weightings are published daily making them the most transparent of any ETF. These ETFs do not have a portfolio manager making investment decisions or portfolio adjustments based on market conditions. Therefore, they are considered to be passive investments and usually have the lowest fees. An investor whom is confident with their ability to structure their own portfolio and is concerned mainly about fees, would be the ideal investor for this type of Exchange Traded Fund.

Rules-Based ETFs take a goal oriented approach rather than following an index exactly. They are constructed based on a defined methodology in order to achieve a specific objective. These types of ETFs follow an index focused on areas of the market that may offer higher returns or lower risks than standard ETFs. To do this, they will use alternative weighting schemes that are based on a variety of criteria, which may include dividends, volatility and/or revenue. Years ago, the TSX experienced significant fluctuations due to the large weighting that Nortel held on the exchange; essentially this type of ETF would construct a portfolio adjusting the weightings of the underlying stocks to create a more ‘balanced’ portfolio. These ETFs retain the characteristics of passive investing including greater transparency. They will have lower fees than Active ETFs, but higher fees than Standard ETFs. They are also known as Smart Beta ETFs.

Active ETFs are constructed and managed almost exactly the same as regular mutual funds. The portfolio manager has the ability to trade the underlying stocks/bonds as they see fit. The main difference is the timing of the trading. An active mutual fund manager can make trades immediately when ever market conditions and/or investment opportunities arise. Due to the way ETFs are constructed and traded on the exchange, making a change to the portfolio may take up to a week to process and/or implement. This is the type of ETF that could invest in a particular sleeve of underlying stocks; an example would be the Horizons Active Emerging Markets Dividend ETF. In order for an Active ETF to be successful the manager must maintain a balance between transparency and the need to be discreet about portfolio changes. Therefore, theses ETFs are less transparent and have higher fees than Standard or Rules-Based ETFs.

As you may already be aware, we at Security Financial are now authorized to recommend ETFs to clients. If you want more information or would like to explore whether adding ETFs to your portfolio makes sense, please don’t hesitate to contact me.

Have a great weekend,

Tracey

 

Source: Canadian Securities Commission, ETFs for Mutual Fund Representatives course material.

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