Exchange-Traded Funds Overview

Exchange-Traded Funds (ETFs)

• ETFs are investment vehicles combining features of mutual funds and individual stocks
• They are structured as open-ended mutual fund trusts
• Regulated similarly to mutual funds (National Instrument 81-102)
• Can also be subject to National Instrument 81-104 (commodities and derivatives)
• Managed actively or passively
• Passive ETFs track specific market indexes (e.g., S&P/TSX 60, S&P 500)
• ETFs are traded on stock exchanges
• Can be bought on margin or sold short
• Some have options available

Learning Objectives

• Explain regulatory requirements and different legal structures of ETFs
• Describe key features of exchange-traded funds
• Differentiate among types of ETFs
• Identify and explain risks specific to ETFs
• Compare and contrast ETFs and mutual funds
• Summarize taxation impacts of investing in ETFs
• Identify investment strategies involving ETFs
• Define mutual funds of ETFs and exchange-traded notes (ETNs)

Content Areas

• Regulation and structure of exchange-traded funds
• Key features of exchange-traded funds
• Various types of exchange-traded funds
• Risks of investing in exchange-traded funds
• Comparison of exchange-traded funds and mutual funds
• Taxation of investors in exchange-traded funds
• Investment strategies using exchange-traded funds
• Other related products

Key Terms

• Active ETFs
• Core holdings
• Commodity ETFs
• Covered call ETFs
• Designated broker
• Equity-based ETFs
• ETF Facts
• Exchange-traded funds
• Exchange-traded notes
• Full replication
• Futures-based ETFs
• In-kind exchange
• Inverse ETFs
• Leveraged ETFs
• Physical-based ETFs
• Prescribed number of units
• Roll yield loss
• Rule-based ETFs
• Satellite holdings
• Spot price
• Synthetic ETFs
• Tracking error

Introduction

• ETFs combine features of mutual funds and individual stocks
• Structured as open-end mutual fund trusts, regulated like mutual funds
• Professionally managed, actively or passively
• Traded on exchanges like individual stocks
• Can be bought on margin and sold short
• Some have options available

Mutual Funds Trusts and Mutual Fund Corporations

• ETFs in Canada are structured as mutual fund trusts or corporations
• Regulated by National Instrument (NI) 81-102
• Can be bought/sold by SRO registered mutual fund dealers and investment dealers.
• Include index and active ETFs

General Disclosure Requirements

• ETFs mostly use the client disclosure documents system (NI 41-101) to distribute ETFs.
• An ETF Facts document, similar to a mutual fund's Fund Facts document, accompanies ETFs
• This document addresses trading and pricing aspects, premiums/discounts, and more.

ETF Facts Document

• Includes essential information on ETF trading and pricing characteristics
• Provides information about market price and bid-ask spreads, premiums & discounts, and more.

Creation and Redemption Process

• ETFs launched through a designated broker
• The broker is a market maker or specialist.
• ETFs are open-end funds with unlimited supply
• Creation/redemption is in blocks (prescribed number of units) of units
• Units are exchanged for underlying securities (via in-kind exchange)

Key Features of ETFs

• Low cost: Management expense ratio (MER) lower typically compared to other products
• Tradability: Liquid, continuous price discovery
• Low tracking error: Prices closely adhere to benchmark.
• Tax efficiency: Lower portfolio turnover
• Transparency: Daily holdings or monthly disclosures (or both)
• Low cost diversification: Allows broader asset allocation
• Targeted exposure: Access to specific market segments (like country or sector-specific ETFs).

Tradability, Liquidity, and Continuous Price Discovery

• ETFs trade on exchanges continuously, allowing continuous price discovery
• Liquidity comes from underlying holdings, not ETF units themselves
• ETFs can be held on margin/shorted

Low Tracking Error

• Tracking error: difference between ETF and underlying index returns
• Lower costs of administration/trading in ETFs contribute to lower tracking errors

Tax Efficiency

• Index-based ETFs have low portfolio turnover, leading to fewer capital gains
• In-kind creation/redemption reduces taxable events associated with mutual funds.

Transparency

• ETFs are required to have holdings published regularly (daily in the U.S., monthly/quarterly in Canada)
• Improves investor visibility

Low-Cost Diversification

• ETFs offer broad exposure to stocks, bonds, and various managers (cost-effective)

Targeted Exposure

• Provide access to specialized asset classes or regions previously difficult or expensive for retail investors
• Investment opportunities are expanded

Types of ETFs

• Standard (index-based): replicates the index closely
• Rules-based: follow a particular methodology to achieve a specific objective, often using alternative weighting schemes
• Active ETFs: actively managed, similar to typical mutual funds
• Synthetic ETFs: derived from derivatives (e.g., swaps), not holding direct exposure to the index
• Leveraged ETFs: attempt to achieve returns multiples of the benchmark
• Inverse ETFs: aim for movements that are the inverse of the benchmark’s movements.
• Commodity ETFs: invest in physical, futures-based, or equity-based commodity holdings

Active Exchange-Traded Funds (ETFs)

• Increasingly popular, actively managed like typical mutual funds
• Trading timed differs, since it can change quicker

Synthetic ETFs

• Created using derivatives like swaps, but not holding direct index exposure
• Exposure is notional, not real

Leveraged ETFs

• Use derivatives to leverage return effects of benchmark, sensitive to market fluctuations.
• More volatile than ordinary ETFs

Inverse ETFs

• Mimic inverse (opposite) movements of benchmark
• Highly complex; risky for holding periods beyond a single trading session

Commodity ETFs

• Physical-based ETFs: invest in physical commodities
• Futures-based ETFs: utilize futures contracts, potentially involving roll-yield losses
• Equity-based ETFs: invest in companies involved in commodity exploration or processing

Covered Call Exchange-Traded Funds (ETFs)

• Employ covered call strategies to enhance yield and reduce volatility (using options)
• Similar to typical strategies, but applied via ETFs.

Risks of Investing in ETFs

• Tracking error: Difference between ETF and index performance/returns
• Concentration risk: Over-reliance on a few holdings within the ETF
• Composition risk: ETFs may have different weighting methodologies in comparison to benchmark
• Securities lending risk: Risk of default by entities from which the ETFs lend assets

Comparing ETFs and Mutual Funds

• Compared to mutual funds, ETFs frequently have lower tracking errors, lower management expenses and higher transparency.

Taxation of Investors in ETFs

• Tax implications from distributions, dividends, interest, and capital gains
• Distributions can be dividends/interests, capital gains, or non-taxable
• Capital gains are generally 50% taxable

Investment Strategies Using ETFs

• Using ETFs for core/satellite portfolio construction
• Asset rebalancing, tactical asset allocation, cash management, exposure to niche markets, tax loss harvesting

Other Related Products

• Mutual funds of ETFs
• Exchange-traded notes (ETNs)