Exchange-traded fund

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An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks.[1][2] An ETF holds assets such as stocks, bonds, Cash and cash equivalents, or commodities, and trades close to its net asset value (NAV) over the course of the trading day. Many ETFs track an index, such as a stock index or bond index[2], i.e. they are passively managed, but actively managed ETFs are increasingly available.

Index ETFs may be attractive as investments because of their simplicity, low costs and tax efficiency.[1][3] An ETF often can be found that has a lower expense ratio than similar mutual funds, in part because of the passive management (no need for a highly paid management team to analyze and select investments), and also because of the ETF structure.[1][2]

At the end of 2022, ETF providers in Canada were managing nearly $340 billion in assets.[4] Almost any "good-for-you" asset class is covered by the >1000 ETFs trading on Canadian stock exchanges, largely in Canadian dollars. But Canadians also have access to an even larger number of ETFs trading on US exchanges, typically in US dollars.

This article starts with an overview of how ETFs work, including the similarities and differences with mutual funds. The article then looks at the main ETF providers in Canada and summarizes the advice on how to choose ETFs for long-term investors. Finally, it explores some trading tips and ETF trends.

How ETFs work

ETFs versus open-ended mutual funds

ETFs are investment funds: they pool money from many investors to manage a portfolio of securities. In that respect, they are like mutual funds. But most mutual funds are open-ended, meaning that you can buy or sell units by dealing with the fund company (directly on indirectly). In the mutual fund structure, new units are created or destroyed at the end of each trading day, at the NAV.

With an ETF, instead, you are typically buying shares from, or selling them to, other investors, through a stock exchange, an operation which does not change the total number of shares/units in circulation (or the ETF’s total market value).[1] ETF shares trade throughout the day. Certain investment professionals (known as Designated Brokers or Designated Market Makers), however, can buy new ETF shares, or redeem existing ones, directly from the ETF providers[1], as explained below. This should maintain prices close to the NAV.

ETFs versus closed-end funds

In contrast, closed-end funds also trade throughout the trading day on stock exchanges, but their prices that may be significantly more or less than the NAV.[5] Closed-end funds are not considered to be "ETFs", even though they are funds and are traded on an exchange.[5]

ETF history

The creation of the modern ETF has roots on Toronto Stock Exchange with a security called TIPs 35; short for Toronto 35 Index Participation Units.[1] This investment product allowed investors to participate in the performance of the TSE 35 Composite Index without having to buy shares of each constituent company in the index.[6] TIPs 35 units were first listed on Toronto Stock Exchange in March 1990.[1] They were followed by the TIPS 100 fund which tracked the broader TSE 100 Index.[6] These two funds were eventually merged in 2000, into Ishares's XIU which still exists.

The first US ETF was launched in 1993.[1]

Creation and redemption of ETF shares

The price of an ETF is determined by the market and the bid and ask prices. ETFs often trade and have a closing price at a slight premium or discount to their underlying NAV. Theoretically this price difference should be arbitraged away by the authorized participants (in Canada: Designated Brokers or Designated Market Makers[1]).

Only authorized participants, which are large broker-dealers that have entered into agreements with the ETF's distributor, actually buy or sell shares of an ETF directly from or to the ETF, and then only in creation units, which are large blocks of tens of thousands of ETF shares, usually exchanged in-kind with baskets of the underlying securities. Authorized participants may wish to invest in the ETF shares for the long-term, but they usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates the net asset value of the underlying assets.[7] Essentially the role of the authorized participants is to close price dislocations by either giving the ETF more assets in exchange for newly created shares, or by buying existing shares in the market and redeeming them in return for assets from the fund. Other investors, such as individuals using a discount broker, trade ETF shares on the secondary market.

ETF shares are created when an “authorized participant” (typically a large institutional investor) deposits a daily “creation basket” (or cash) with the ETF and the ETF issues to the authorized participant a “creation unit,” a large block of ETF shares (generally 25,000 to 200,000 shares). The redemption process works in reverse, an authorized participant presents the specified number of ETF shares to the ETF in exchange for a “redemption basket” of securities, cash, or both, which typically mirrors the creation basket.

The creation and redemption of units helps to keep the trading price of the ETF near the net asset value (NAV) of the ETF holdings. Deviations between an ETF’s market price and its underlying value create opportunities for arbitrage for authorized participants. The ability of authorized participants to create and redeem ETF shares helps the ETF to trade at a price that approximates its underlying value.

ETF providers

At the end of 2022, there were 42 ETF providers in Canada managing 1047 funds.[4]

The ETF providers can be distinguished by the differences in the philosophy, style and underlying indices used for their offerings. They can also be distinguished by the degree to which they tend to offer broad versus specialized products, and passive (index) versus active funds. The following table lists the top-five providers by assets under management in the ETF market in Canada:

Provider # of ETFs[4] AUM ($B)[4] Asset-weighted
management fee[8] 		Website link
BlackRock Canada (Ishares) 144 93 0.23% link
BMO Asset Management 131 88 0.26% link
Vanguard Canada 37 50 0.14% link
Horizons ETFs 107 23 0.30% link
CI Investments 81 16 0.53% link
Total all providers 1046 340 0.29%

TMXMoney maintains a list of all Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) that are publicly traded, sorted alphabetically by symbol.

How to choose ETFs for index investors

Selecting plain-vanilla index ETFs

See also: Indexing § Indexing_considerations

ETFs are excellent building blocks for simple index portfolios or more complex passively managed portfolios. But with over 1000 ETFs now listed on the TSX (see the table above) and thousands more on US exchanges, how does an index investor choose the right ETF for each asset class? Most index investors will opt for ETFs that follow the broadest possible indices using market capitalisation weights; these are also known as “plain-vanilla” ETFs. Examples of those are listed under Canadian equities, US equities, International equities and emerging markets. For plain-vanilla Canadian bond ETFs see conventional bonds.

Additional criteria include:

  • assets under management at least $50 million (to make sure the ETF will still exist next year)[9]
  • good liquidity and low bid-ask spreads (see also [10] and [11])
  • minimal tracking error (see also [12] and [13])

Another aspect to examine, especially for global stocks, is whether the ETF holds stocks directly, instead of holding shares of a US-listed ETF, as this can have tax consequences (see Tax-efficient investing). Currency hedging may or may not be a desirable feature (see US equities and Foreign bonds for example).

If two ETFs under consideration are traded on the same exchange and fit the criteria above, then the one with the smaller management fee can be picked, although differences of a few basis points are totally insignificant compared to, say, picking the appropriate asset allocation or asset location (see [14]).

Canadian vs US-listed ETFs

ETFs covering Canadian asset classes will typically be purchased on Canadian exchanges. But ETFs covering asset classes such as foreign stocks, foreign bonds or gold can be bought either on the TSX or on US exchanges.

ETFs listed in Canada have the following advantages:

  • A wide range of products is now available[15]
  • You buy them with Canadian dollars (CAD), avoiding currency conversion costs[16] (some funds are also available in US dollar versions if the investor already has USD available)
  • Some ETFs are hedged to CAD, which can be a desirable feature, especially for foreign bonds (see Currency hedging)
  • ETFs listed in Canada do not increase your potential US estate tax exposure (see Death and taxes: US estate tax exposure), even for ETFs covering US, international developed or emerging market stocks
  • All-in-one asset allocation ETFs customized for Canadian investors are available

US-listed ETFs have the following advantages:

  • They can provide an even wider selection of products, although those only available on US exchanges now tend to be niche offerings
  • They may have lower MERs
  • They are sometimes more tax-efficient, in some accounts, although this is a complex issue

If the investor buys US-listed ETFs with Canadian dollars, there will be currency conversion fees which can be high at some brokerages. Norbert's Gambit is one available option that can be utilized to minimize the currency conversion costs when buying or selling US-listed ETFs. Where possible, using a discount brokerage sub-account that matches the currency of the ETF helps to minimize currency conversion costs when distributions are received.

Asset allocation ETFs

Main article: Asset allocation ETF

An alternative to selecting one ETF per asset class is to buy a single asset allocation ETF. These are complete portfolios with low fees and global diversification. Different stock/bond splits are available.

ETF trading tips

Long-term investors can use the following tips when buying or selling ETFs in their discount brokerage account:

  • Place orders only within market hours (typically 9.30 A.M.-4.00 P.M. Eastern Time in Toronto and New York), not before or after[17]
  • Furthermore, avoid trading during the first and last 30 mins of the session (during which markets are the most volatile and spreads can be higher)[18]
  • Use limit orders[19]

Investors seeking to buy or sell positions in the less actively traded ETFs may also find that there may be poor liquidity and/or large bid-ask spreads.[20] Additionally, many of the sector ETFs contain only a small number of stocks. Purchasers are encouraged to check the data provided on the vendor's website carefully before making a decision.

ETF trends

Recent developments

The early ETFs tracked broad indices and were an important innovation, allowing investors instant diversification at low cost. While the "good-for-you" plain-vanilla ETFs are still around (see the section above on how to find them), and are cheaper than ever due to competition between providers[21], many recent developments in the ETF market have been less closely aligned with investors' long term best interests.[22] Morningstar writes that "the best options have been on the menu for a long time ... the odds of something better coming to market have grown slimmer over time".[22]

As of early 2023, index ETFs represent 64% of ETF assets in Canada, while actively managed ones have 28% and "smart beta" ones have 8% of assets.[1] Many new products are appearing every year as shown below. Since all the main broad asset classes are already well covered by index ETFs offered by several providers which compete on cost, many recent ETF offerings have been active, sector, "theme" or "flavour of the month"-type products. With these specialized products, ETF providers compete for investors' attention and cater to investors' gambling instincts, while charging higher fees.[21] Unfortunately, this does not end well on average:

Strikingly, over their first 5 years, specialized ETFs lose about 30% (risk-adjusted). This underperformance cannot be explained by high fees or hedging demand. Rather, it is driven by the overvaluation of the underlying stocks at the time of the launch. Our results are consistent with providers catering to investors’ extrapolative beliefs by issuing specialized ETFs that track attention grabbing themes.[21]

Among this proliferation of avoidable products, one important development has been the launch of asset allocation ETFs by Vanguard Canada in 2018, followed quickly by Ishares and BMO, among others. These are low-maintenance all-in-one portfolios and they have been described as "the greatest gift to come along in decades" for DIY investors.[23]

Statistics

The following tables show the growth of ETFs in the Canadian market and the US market (for comparison purposes).

Canada ETF statistics
Year end # of ETFs Assets ($ Billions) New ETFs Closed ETFs
2009 111 32 34 0
2010 159 38 50 2
2011 227 43 70 0
2012 265 56 45 14[notes 1]
2013 284 63 44 27
2014 340 77 78 19
2015 373 90 73 27
2016 456 114 97 9
2017 553 147 169 24
2018 660 157 140 14
2019 748 205 143 37
2020 846 257 173 38
2021 965 349 201 35
2022 1047 340 N.A. N.A.
Sources: Morningstar Inc.[24][25]; Canadian ETF Association (CETFA)[26][27][28][29][30][31][32][33][34][35][36][37]; National Bank[9]

Notes

  1. ^ New and Closed ETFs as of December 7, 2012.
US ETF statistics[38]
Year end # of ETFs Assets ($ Billions) New ETFs Closed ETFs
1993 1 0.5 N.A. N.A.
1994 1 0.4 N.A. N.A.
1995 2 1.1 N.A. N.A.
1996 19 2.4 N.A. N.A.
1997 19 6.7 N.A. N.A.
1998 29 16 N.A. N.A.
1999 30 34 N.A. N.A.
2000 80 66 N.A. N.A.
2001 102 83 22 0
2002 113 102 14 3
2003 119 151 10 4
2004 152 228 35 2
2005 204 301 52 0
2006 359 423 156 1
2007 629 608 270 0
2008 728 531 149 50
2009 797 777 120 49
2010 923 992 177 51
2011 1,135 1,048 226 15
2012 1,195 1,337 141 81
2013 1,295 1,675 147 46
2014 1,412 1,975 196 59
2015 1,595 2,101 274 75
2016 1,716 2,524 230 97
2017 1,835 3,401 254 114
2018 1,988 3,171 240 84
2019 2,096 4,396 235 110
2020 2,203 5,449 316 182
2021 2,570 7,171 457 59
2022 2,844 6,477 414 120

In 2022, 12% of US households held ETFs.[38]

See also

References

  1. ^ a b c d e f g h i j Canadian ETF Association (CEFTA), Guide to the Canadian ETF Industry, 4th edition, summer 2023, viewed September 1, 2023.
  2. ^ a b c Vanguard Canada, Vanguard index ETFs, viewed September 2, 2023.
  3. ^ Vanguard Canada, Are ETFs tax-efficient?, viewed March 9, 2018.
  4. ^ a b c d Canadian ETF Association, Year End Statistics for the Canadian ETF Industry as of December 31, 2022, viewed August 30, 2023.
  5. ^ a b Investopedia, Closed-End Fund, viewed February 6, 2021.
  6. ^ a b Justin Bender, Understanding Canadian Equity ETFs, January 22, 2019, viewd September 2, 2023.
  7. ^ ETF Basics: The Creation and Redemption Process and Why It Matters, viewed September 15, 2012.
  8. ^ The Cerulli Report, Chapter 2: Canadian ETFs, Exhibit 2.03 Canadian ETF Issuers Ranked by Assets, 2Q 2022, viewed September 3, 2023.
  9. ^ a b Investment Executive, Exchange-traded duds, October 11, 2022, viewed September 4, 2023.
  10. ^ Canadian Couch Potato, ETF Liquidity and Trading Volume, viewed Dec. 27, 2014
  11. ^ Canadian Couch Potato, The Hidden Cost of Bid-Ask Spreads, viewed Dec. 27, 2014
  12. ^ Canadian Couch Potato, How Well Does Your ETF Track Its Index?, viewed Dec. 27, 2014
  13. ^ Canadian Couch Potato, What Causes an ETF’s Tracking Error?, viewed Dec. 27, 2014
  14. ^ Canadian Couch Potato, ETF Choices Are Less Important Than You Think, viewed Dec. 27, 2014
  15. ^ Rob Carrick, Why Canadian investors should stop buying U.S.-listed ETFs, February 4, 2021, viewed October 2, 2021.
  16. ^ Dan Bortolotti, Is it worth it to buy U.S.-listed ETFs?, MoneySense, July 17, 2017, viewed October 2, 2021.
  17. ^ Canadian Couch Potato blog, ETF Investors: Avoid the After-Hours Club, June 17, 2013, viewed January 20, 2021.
  18. ^ The two times during market day when investors should never trade, CNBC, ETF Strategist, January 27, 2017, viewed January 20, 2021.
  19. ^ ETF market makers advise using limit orders, Investment Executive, March 31, 2014, viewed January 20, 2021.
  20. ^ Riepe MW, Iachini M, Volume and Assets as Determinants of ETF Bid-Ask Spreads, Journal of Financial Planning, viewed March 2, 2019.
  21. ^ a b c Ben-David I, Franzoni F, Kim B, Moussawi R (2023) Competition for Attention in the ETF Space, Review of Financial Studies 36:987–1042, available at SSRN.
  22. ^ a b Morningstar, The Best and Worst New ETFs of 2021
  23. ^ Canadian Couch Potato, How to Set Up a Hands-Off ETF Portfolio, January 28th, 2020, viewed September 2, 2023.
  24. ^ Record number of ETFs shutting down - The Globe and Mail, viewed September 13, 2012.
  25. ^ The year of the ETF closure|Morningstar, viewed December 8, 2012.
  26. ^ CETFA Quarterly Report (Dec 30, 2011), viewed February 20, 2014.
  27. ^ Canadian ETF Industry Has Record Year, viewed February 20, 2014.
  28. ^ CETFA December 2013 Statistics (January 10, 2014), viewed February 20, 2014.
  29. ^ CETFA December 2014 Statistics, viewed December 29, 2015.
  30. ^ CETFA December 2015 Statistics, viewed October 29, 2017.
  31. ^ CETFA December 2016 Statistics, viewed October 29, 2017.
  32. ^ CETFA Monthly Report - December 31, 2017, viewed January 20, 2021.
  33. ^ CETFA Monthly Report - December 31, 2018, viewed January 20, 2021.
  34. ^ CETFA Monthly Report - December 31, 2019, viewed January 20, 2021.
  35. ^ CETFA, Canadian ETF Assets as of December 31, 2020, viewed September 3, 2023.
  36. ^ CETFA, Canadian ETF Assets as of December 31, 2021, viewed September 3, 2023
  37. ^ CETFA Monthly Report - December 31, 2022, viewed September 3, 2023.
  38. ^ a b 2006 Investment Company Fact Book, viewed September 4, 2023; 2013 Investment Company Fact Book, viewed February 22, 2014; 2017 Investment Company Fact Book, viewed October 29, 2017; 2019 Investment Company Fact Book, viewed October 29, 2019; 2020 Investment Company Factbook, viewed September 4, 2023; 2023 Investment Company Fact Book, Chapter 4 US Exchange-Traded Funds, viewed September 4, 2023.

External links

  • The Canadian ETF Association
  • "Thinking of investing in exchange-traded funds (ETFs)? Read the ETF Facts first!". Canadian Securities Administrators (CSA).
  • Bogleheads wiki, Exchange-traded fund
  • Bogleheads wiki, List of US ETF providers
  • Eight tips for trading ETFs, Investment Executive, January 2020
  • RBC (an ETF provider), ETF Glossary
  • BlackRock (an ETF provider), ETF education centre, including a glossary
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