Exchange-Traded Funds PDF

Exchange-Traded Funds 19 CHAPTER OVERVIEW In this chapter, you will learn about the regulation, structure, and taxation of exchange-traded funds. We will also discuss features, risks, and various types of exchanged-traded funds, as well...

Exchange-Traded Funds 19 CHAPTER OVERVIEW In this chapter, you will learn about the regulation, structure, and taxation of exchange-traded funds. We will also discuss features, risks, and various types of exchanged-traded funds, as well as common strategies. LEARNING OBJECTIVES CONTENT AREAS 1 | Explain the regulatory requirements and The Regulation and Structure of Exchange- different legal structures of ETFs. Traded Funds 2 | Describe the key features of exchange-traded Key Features of Exchange-Traded Funds funds. 3 | Differentiate among the types of ETFs. The Various Types of Exchange-Traded Funds 4 | Identify and explain the risks specific to ETFs. The Risks of Investing in Exchange-Traded Funds 5 | Compare and contrast ETFs and mutual funds. Comparing Exchange-Traded Funds and Mutual Funds 6 | Summarize the taxation impacts of investing Taxation of Investors in Exchange-Traded in ETFs. Funds 7 | Identify the investment strategies involving Investment Strategies Using Exchange- ETFs. Traded Funds 8 | Define mutual funds of ETFs and exchange- Other Related Products traded notes (ETNs). © CANADIAN SECURITIES INSTITUTE 19 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. active ETFs inverse ETFs core holdings leveraged ETFs commodity ETFs physical-based ETFs covered call ETFs prescribed number of units designated broker roll yield loss equity-based ETFs rules-based ETFs ETF Facts sampling exchange-traded funds satellite holdings exchange-traded notes spot price full replication synthetic ETFs futures-based ETFs tracking error in-kind exchange © CANADIAN SECURITIES INSTITUTE  CHAPTER 19      EXCHANGE-TRADED FUNDS 19 3 INTRODUCTION An exchange-traded fund is an investment vehicle that combines some features from mutual funds and some from individual stocks. They are typically structured as open-end mutual fund trusts and are regulated like any other mutual funds, subject to National Instrument 81-102. In certain cases, they are also subject to National Instrument 81-104, which addresses funds that use commodities and derivatives, either alone or in combination. Similar to mutual funds, exchange-traded funds are professionally managed products, either actively or passively. Passive management constructs a portfolio of securities that track specific market indexes, such as the S&P/TSX 60 Index or the S&P 500 Index. Most exchange-traded funds are passively managed, but the number of actively managed exchange-traded funds is increasing. Unlike open-end mutual funds, units of an exchange-traded fund trust are listed and traded on a stock exchange or an alternative trading system, much like individual stocks. Because they are traded on an exchange, exchange- traded funds can be bought on margin and sold short, and some have options trading on them. THE REGULATION AND STRUCTURE OF EXCHANGE-TRADED FUNDS 1 | Explain the regulatory requirements and different legal structures of ETFs. Exchange-traded funds (ETF) are regulated under either of two national instruments, depending on their structure. The different structures and regulatory requirements are described below. MUTUAL FUND TRUSTS AND MUTUAL FUND CORPORATIONS Much like the way mutual funds are structured, ETFs in Canada are structured as mutual fund trusts or as mutual fund corporations. Both ETF classification structures are regulated according to National Instrument (NI) 81-102 and can be bought and sold by SRO registered mutual fund dealers and investment dealers. Several types of ETFs under these structures include index and active ETFs. Under NI 81-102, the use of leverage and the use of derivatives for non-hedging purposes is generally limited. DID YOU KNOW? Individuals licensed as investment advisors can deal in any type of ETF that is registered under NI 81-102. However, not all ETFs are created or structured the same. Because of the derivatives components and investment strategies of synthetic, leveraged, inverse, and commodity ETFs, mutual fund representatives are generally not allowed to deal in these types of ETF products, unless they meet a higher level of proficiency. GENERAL DISCLOSURE REQUIREMENTS FOR EXCHANGE-TRADED FUNDS ETFs predominantly use the client disclosure documents system to qualify the distribution of ETFs to the public. The actual requirements of this system are set out in NI 41-101. ETF FACTS DOCUMENT ETFs must produce and file a summary disclosure document called ETF Facts. This document is designed to look like the Fund Facts document that accompanies a mutual fund. However, ETFs differ from mutual funds in some key ways, which the ETF Facts must reflect. In addition to the standard information presented in a Fund Facts © CANADIAN SECURITIES INSTITUTE 19 4 CANADIAN SECURITIES COURSE      VOLUME 2 document, the ETF Facts document must address the trading and pricing characteristics of ETFs. For example, the ETF Facts document includes information related to market price and bid-ask spread, as well as to premium and discount of market price to the net asset value (NAV). An amendment to NI 41-101 has also introduced a new disclosure delivery regime for ETFs as of December 10, 2018. Because ETFs are exchange traded, the delivery mechanism differs from that of mutual funds. The ETF Facts document is distributed through the dealer where the ETF is purchased. The amendment requires dealers receiving a purchase order for ETF securities to deliver the ETF Facts document to investors, instead of the prospectus, within two business days of the purchase. The dealers are also required to make the prospectus available to investors, upon request, at no cost. Under the proposed amendment, investors who do not receive the ETF Facts document have the right to seek damages or to rescind the purchase. DID YOU KNOW? As part of ETF disclosure requirements, a Long Form Prospectus must be filed with the securities commission annually. It does not need to be updated annually unless there is a change in the affairs of the ETF. As with a Simplified Prospectus, the long form must be written in plain language and set up in a standard, easily navigated format. The prospectus must be mailed or otherwise delivered to purchasers upon their request. For further purchases of the same ETF, it is not necessary to provide the prospectus or ETF Facts document again unless the documents have been amended or renewed. Furthermore, ETFs are subject to the same continuous disclosure requirements as other mutual funds regarding annual audited financial statements and management reports. CREATION AND REDEMPTION PROCESS OF A STANDARD EXCHANGE- TRADED FUND When an ETF provider wants to launch a new ETF, it does so through a designated broker with whom it has entered into a contractual agreement. The designated broker may be a market maker or a specialist representing a large investment dealer. DID YOU KNOW? ETFs are open-end funds, which means that there can be an unlimited supply to meet increasing demand. ETFs are created or redeemed in blocks of units known as a prescribed number of units – typically consisting of 10,000, 25,000 or 50,000 ETF units. If an ETF is designed to track a particular index, the designated broker buys (or borrows from a securities lender) shares in all of that index’s component parts, in increments set by the respective ETF provider. The designated broker then delivers the basket of shares to the ETF provider. In exchange, the ETF provider gives the designated broker the prescribed number of units, which the broker can break up and sell as individual ETF units in the open market. © CANADIAN SECURITIES INSTITUTE  CHAPTER 19      EXCHANGE-TRADED FUNDS 19 5 EXAMPLE The following common shares comprise an index of only five securities and shows the number of shares that are required to form a basket of securities set by the ETF provider that can be exchanged for a prescribed number of ETF units. In this example, the designated broker can deliver the basket of stocks described below in exchange for the prescribed number of units of 50,000. Common Share Issuer Basket of Shares Current Price Total Value ABC Corp. 1,500 $59.62 $89,430 DEF Corp. 1,785 $71.50 $127,628 JKL Corp. 2,312 $47.38 $109,543 MNO Corp. 1,482 $25.93 $38,428 QRS Corp. 2,112 $15.01 $31,701 Total Value $396,730 If the designated broker delivers the basket of shares with a value of $396,730 to the ETF provider, the ETF provider in turn will deliver 50,000 ETF units to the designated broker, where the value per unit would be $7.93 (calculated as $396,730 ÷ 50,000). The total value of the basket of stocks divided by the prescribed number of units determines the value per ETF unit to be sold in the marketplace. The process also works in reverse: the designated broker can remove ETF units from the market by purchasing enough units to form the prescribed number for a unit. The broker then exchanges the unit with the ETF provider for the underlying shares that comprise the index. Reasons why a designated broker may remove ETF units from the market include declining demand for an ETF, or to take advantage of arbitrage opportunities when an ETF is trading at a discount to the securities it holds (by purchasing the cheaper ETF units and exchanging them for the securities and selling the higher priced securities, the designated broker can earn a profit). One key reason why ETFs are relatively cheap in terms of MERs compared to mutual funds is because designated brokers normally pay trading costs and fees associated with the purchase and sale of the underlying securities that comprise the index. Designated brokers make their money from the bid/ask spread, as investors buy and sell the ETFs. Not only does this system result in lower trading costs, it also creates a fairer system for paying those costs. In the case of mutual funds, all unitholders pay the costs associated with carrying out a single investor’s trading instruction. With ETFs, the trading costs of a single buyer or seller are paid for directly by that buyer or seller, largely through the bid/ask spread of the ETF (as well as any trading commissions). Basically, the creation and redemption process involves the designated broker buying and selling ETF units and exchanging them with the ETF provider for the ETF’s underlying securities. This process, as shown in Figure 19.1, is a key feature of ETFs. The feature is known as an in-kind exchange because a basket of stocks is exchanged for ETF units, rather than for cash. © CANADIAN SECURITIES INSTITUTE 19 6 CANADIAN SECURITIES COURSE      VOLUME 2 Figure 19.1 | In-Kind Exchange Process ETF Company Basket of Prescribed Number Underlying Stocks of ETF Units Designated Brokers ETFs Shares Sellers Stock Exchange Buyers Through the in-kind exchange process, both parties benefit from the transaction: the ETF provider receives the stocks it needs to track the index and the designated broker receives ETF units to resell. In addition, investors benefit from lower trading costs because the process keeps the price of the ETF in line with the NAV of its underlying securities. For example, if the traded value of the ETF strays too far above the NAV of the underlying securities, the designated broker or other institutional players can attempt to profit from this arbitrage opportunity. To do so, they buy the underlying securities in the open market, redeem them for the prescribed number of ETF units, and then sell the units in the open market. EXAMPLE An ETF is trading on an exchange at $20, but the NAV of the underlying stocks upon which it is based is $19.50. A designated broker buys the basket of underlying stocks and exchanges it with the ETF provider for a prescribed number of ETF units. The designated broker then sells the new ETF shares and shows a profit of $0.50 per share. This action puts downward pressure on the ETF price (because new shares are entering the market) and upward pressure on the underlying share prices. Conversely, more pressure to sell ETFs can result in the ETF trading at a discount to the NAV of the underlying securities. For example, using the above figures, the NAV is $20.50. In this case, the designated broker can purchase a prescribed number of units of the ETF at $20 per share on the open market and redeem them for the underlying securities. The designated broker can then sell the underlying securities and earn a $0.50 profit. This process puts some upward pressure on the ETF price and downward pressure on the underlying securities, moving the relationship back towards one that reflects fair value. Because more than one designated broker often follows the respective ETFs and quotes on the trades, the exchange process provides liquidity to the markets and creates competition among the designated brokers and market makers. These examples do not take trading costs into consideration. Naturally, the spread between the NAV and ETF price would have to be large enough to provide the designated broker with a profit net of these costs. © CANADIAN SECURITIES INSTITUTE  CHAPTER 19      EXCHANGE-TRADED FUNDS 19 7 KEY FEATURES OF EXCHANGE-TRADED FUNDS 2 | Describe the key features of exchange-traded funds. ETFs have the following key features: Low cost Tradability, liquidity, and continuous price discovery Low tracking error Tax efficiency Transparency Low cost diversification Targeted exposure Each of these features is explained briefly below and in more detail throughout the course. LOW COST ETFs generally have a significantly lower management expense ratio (MER) compared to other managed products and mutual funds. The MER is lower because most ETFs are passively invested; therefore, they do not bear the costs of active portfolio management. Index mutual funds are passively managed as well, but ETFs tend to have lower costs than even those funds. The primary reason is that ETFs are traded on an exchange, where the administrative costs of record-keeping, issuance of prospectus documents and client statements, and handling of client inquiries are borne by the dealer member that holds the client accounts. With index mutual funds, these costs are carried by the mutual fund company and get passed on directly to the investor. DID YOU KNOW? As described in an earlier chapter, the efficient market hypothesis states that the prices of securities reflect available information in efficient markets. A passive investing approach is appropriate for investors who believe in the efficient market hypothesis, particularly the strong form. Investors who reject the hypothesis would likely use an active approach. Beyond the lower management costs, ETFs also tend to have lower trading costs than mutual funds. Mutual funds have implicit trading costs related to the need to purchase or sell securities to meet fund flows. ETFs, on the other hand, use an in-kind creation and redemption process, whereby the designated broker buys and sells securities to create and redeem shares. Because the ETF does not have to buy or sell securities, trading expenses incurred by the fund are further reduced. In terms of advisor compensation, ETF purchasers pay a commission (unless the purchase is within a fee-based account, in which case the fee is based on the dollar size of the account). In contrast, mutual funds have a wider variety of advisor compensation structures, including front-end loads and trailer fees. Investors who purchase ETFs outside of a fee-based account can further minimize their commission costs by purchasing through a self-directed broker, where rates are potentially very low. Some ETFs do offer ongoing compensation in the form of a trailer fee, but they represent only a small portion of the ETF industry in Canada. © CANADIAN SECURITIES INSTITUTE 19 8 CANADIAN SECURITIES COURSE      VOLUME 2 TRADABILITY, LIQUIDITY, AND CONTINUOUS PRICE DISCOVERY As with stocks, ETFs enable investors to buy and sell throughout the day, as long as the respective exchanges are open. They can be held on margin or shorted, and options can trade on them. As well, various kinds of orders such as market, limit, and stop orders can be placed on them. The liquidity of ETFs is derived from the underlying securities, rather than the ETF units themselves. Because an ETF is just a basket of securities, and the basket is exchangeable for the underlying assets, the volume of the underlying assets is the true indication of the ETF’s liquidity. ETFs trade on an exchange; therefore, there is continuous and transparent pricing during trading hours. Although this process adds value to all ETFs, the following two types of ETFs benefit in particular: Those that have relatively illiquid underlying assets Those that trade on exchanges while the underlying market is closed (for example, when the underlying market is overseas) In these cases, the underlying asset price discovery process is often accomplished through the ETF. Because it is more accessible than the underlying asset, the ETF can reflect market information as it happens and actually lead the price of the underlying. It is reassuring to investors that the ETF price cannot depart from that of the underlying asset for very long or to a great extent. Arbitrage between the two prices continually forces them to remain in line with each other. Therefore, tracking error is minimized. LOW TRACKING ERROR For ETFs, tracking error is usually defined as the simple difference between the return on the underlying index or reference asset and the return on the ETF. Tracking error can be caused by several factors, including the cost to run the fund, cash drag, and sampling methods. For most ETFs, tracking error is usually less than what is apparent with mutual funds, primarily because the ETF administrative and trading costs are lower. ETFs cannot deviate much from their NAV because of the in-kind creation and redemption process. This process allows market participants to create or redeem ETF shares at the end of each day at their NAV. Therefore, they are able to arbitrage between the ETF itself and the ETF’s underlying securities. If the market price of an ETF deviates from the fund’s NAV, market makers can perform arbitrage until this difference is minimized. However, if arbitrage is difficult and costly to implement, the tracking error level will be higher than normal. Two factors that could make arbitrage difficult and costly are a lack of liquidity and a large number of securities making up the underlying index. TAX EFFICIENCY Index-based ETFs, which make up a large portion of the ETF market, tend to have lower portfolio turnover. Stocks are sold only when there are changes to the index, which results in fewer realizations of capital gains than other investment products (such as actively traded mutual funds). Therefore, fewer taxable events allow the capital to compound over time. In addition, the in-kind creation and redemption mechanism allows most ETFs to avoid certain taxable events. Such events arise with mutual funds, when redemptions take place and securities must be sold to raise cash within the fund. (We discuss the tax implications of investing in ETFs later in this chapter.) TRANSPARENCY In the United States, ETF providers are mandated to publish their holdings daily. In Canada, no such regulatory requirement is imposed on ETF providers. The requirement is the same as it is for mutual funds: top holdings must be published monthly and all holdings quarterly. Nevertheless, index ETFs do publish their holdings daily, and this information is also available from the provider whose index the ETF is tracking. This transparency allows investors © CANADIAN SECURITIES INSTITUTE  CHAPTER 19      EXCHANGE-TRADED FUNDS 19 9 to gauge the attributes offered when the respective ETFs are added to a portfolio. In addition, some ETF providers post their tracking errors to their respective indexes. This record provides further transparency, as investors can measure how well the ETF has tracked the index and its level of dispersion. With respect to actively managed ETFs in Canada, some do publish their holdings daily. However, this is a challenge for these ETFs to balance the trade-off between the benefits of transparency for investors and the competitive risks of disclosing their holdings. LOW-COST DIVERSIFICATION With a single ETF you can have exposure to a broad range of stocks, bonds, market segments, and manager styles. You could also hold an ETF that attempts to mimic the performance of a country or group of countries. Given the high correlations between securities within sectors or asset classes, ETFs offer diversification at a lower cost than mutual funds and other managed products. ETFs can also help to mitigate the risk of holding a single stock or bond, given their typical structure of a basket of securities. Traditional stock pickers increasingly use ETFs to implement their asset allocation strategies. The low-cost diversification of ETFs is one key contributing factor supporting this trend. TARGETED EXPOSURE ETFs allow small investors to access a broad range of assets that were previously difficult and expensive to purchase. Investment opportunities that were once realistically only available to institutional and other large investors have become open to everyone. Therefore, ETFs have helped democratize the investing process and level the playing field between large and small investors. Furthermore, equity ETFs have branched into various sectors and regions, and fixed-income ETFs have been refined for credit quality and term. Investors can therefore now use ETFs to implement investment themes that were previously too difficult and costly to obtain. These new products and innovations have allowed investors to use ETFs to create or supplement their investment portfolios. THE VARIOUS TYPES OF EXCHANGE-TRADED FUNDS 3 | Differentiate among the types of ETFs. The following types of ETFs are available on the market: Standard (index-based) Rules-based Active Synthetic Leveraged Inverse Commodity Covered call Each type is described in detail below. © CANADIAN SECURITIES INSTITUTE 19 10 CANADIAN SECURITIES COURSE      VOLUME 2 STANDARD EXCHANGE-TRADED FUNDS With standard ETFs, the reference index on which the ETF is based can be either exactly replicated or approximately constructed, depending on the method used. Full replication Full replication is often used with equity portfolios of large capitalization stocks because those stocks are extremely liquid investments. In such cases, the ETF holds all of the stocks in the same weight as the respective index. The full replication process tracks extremely close to the benchmark index, with minimal tracking error. Sampling Sampling is the process by which the portfolio manager selects securities and their weighting to best match the performance of the index. This method is typically used to construct portfolios of fixed-income and some international and small cap equity ETFs. The purpose of sampling with fixed-income ETFs is to achieve an outcome that replicates the performance of a large number of bonds that may not be accessible in the open markets. Although sampling is most often used for fixed-income ETFs, it is also used in some cases where full replication is not optimal for equity ETFs. These cases reflect considerations of either liquidity or index construction. With index construction, if the number of holdings within the index is significantly high, sampling makes the ETF more efficient, given the trading costs to reproduce the full index. With a sampling approach, there could be some differences between the index and the performance of the ETF. In most cases, this tracking error is small, but it should be reviewed regularly. Regardless of the method used to replicate the index, the holdings of a standard ETF are the most transparent of any of the ETF types. One of the ideal characteristics of a good benchmark is that investors can identify its membership at any time. This transparency is a key feature of standard ETFs. Typically, the holdings of a standard ETF and their weightings within the index are published by the issuer of the ETF. Naturally, this information is available from the index provider as well. In addition, some ETF providers post their tracking errors to their respective indexes. EXAMPLE An example of a standard ETF is the iShares S&P/TSX 60 Index ETF, which happens to be the largest and most liquid ETF in Canada. This ETF sets out to replicate the performance of the S&P/TSX 60 Index that trades on the Toronto Stock Exchange (TSX). This ETF is the largest ETF traded in Canada. It was launched in 1990 under the name Toronto 35 Index Participation Units, or TIPS for short. RULES-BASED EXCHANGE-TRADED FUNDS Rules-based ETFs take a goal-oriented approach. Rather than following a traditional market-capitalization weighted index, they follow an index focused on the areas of a market that offer higher returns or lower risks than traditional indexes. At the same time, they retain the positive characteristics of passive investing, including lower costs and increased transparency. Rules-based ETFs are constructed based on a defined methodology to achieve a specific objective. They are usually associated with an index; however, some rules-based ETFs do not follow a specific underlying index. In these cases, construction rules are generally developed by the ETF provider and published in advance. The ETF provider follows the rules in the same way it would follow an index. Like traditional ETFs, rules-based ETFs generally attempt to use full replication, with general transparency of the holdings published on the provider’s website. Rules-based ETFs are sometimes called smart beta ETFs because of the strategies they use. Smart beta strategies attempt to deliver a different outcome than conventional market-cap-weighted indexes. To do this, they use alternative weighting schemes, which may be based on any one of various criteria. For example, typical criteria may include volatility, dividends, or top-line revenue. © CANADIAN SECURITIES INSTITUTE  CHAPTER 19      EXCHANGE-TRADED FUNDS 19 11 EXAMPLE An example of a smart beta ETF is the BMO MSCI USA High Quality Index ETF. This ETF has been designed to replicate, to the extent possible, the performance of the MSCI USA Quality Index, net of expenses. The fund invests in U.S. equity markets while screening for high return on equity, stable year-over-year earnings growth, and low financial leverage. ACTIVE EXCHANGE-TRADED FUNDS Most ETFs are index-based. However, a growing number of actively managed ETFs have been launched in the marketplace in recent years. Construction techniques of the active ETF vary according to the sponsor and its investment style (e.g., value or growth-based, top-down or bottom-up, and quantitative or qualitative). The active portion of a fund is constructed and managed no differently than any other active mutual fund. What differs is the timing of trading activity. An active mutual fund manager trades whenever market conditions and opportunities permit. In contrast, a manager in charge of the active portfolio of an ETF may have some restrictions as a result of the in-kind creation and redemption process. Designated brokers must know what is represented by the prescribed number of units, which means that the units cannot trade unless the designated broker knows about any changes. This communication process may take some time. For example, the manager may be permitted to make portfolio changes only at the end of a day or a week. Active ETFs may charge a lower MER fee than an open-end mutual fund that manages a similar portfolio, but generally more than another ETF with a passive benchmark. In the United States, the Securities and Exchange Commission rules dictate that the manager’s trades must be revealed the day after the transactions. In Canada, such trades do not have to be revealed earlier than on a quarterly basis, according to NI 81-106. Therefore, the duration of any possible discrepancy between the ETF unit value and its NAV is minimized in the United States; whereas in Canada, the risk of discrepancy is greater. Compared to passively managed ETFs, actively managed ETFs have less transparency and higher MERs. They are also less tax efficient because portfolio turnover is higher. EXAMPLE An example of an actively managed ETF in Canada is Horizons Active Emerging Markets Dividend ETF. The investment objective of this ETF is to seek long-term returns consisting of regular dividend income and modest, long-term capital growth. Investments are primarily in equity and equity-related securities of companies with operations in emerging market economies. SYNTHETIC EXCHANGE-TRADED FUNDS Synthetic ETFs differ from other types because they do not hold the same underlying exposure as the index they track. These ETFs are constructed with derivatives, such as swaps, to achieve the return effect of the index. As a result, the exposure of synthetic ETFs is notional, rather than real. DID YOU KNOW? Swaps are over-the-counter derivatives that are privately negotiated between two counterparties. They can be thought of as a series of forward contracts and are subject to the same pricing factors, namely cost-of-carry (which includes such costs as financing, storage, and insurance). Simply put, each counterparty agrees to swap fixed and variable cash flows based on the price of a reference asset over a period of time. © CANADIAN SECURITIES INSTITUTE 19 12 CANADIAN SECURITIES COURSE      VOLUME 2 Swap-based synthetic ETFs are less transparent to the retail investor than their physical versions, where the underlying assets consist of stocks, bonds, or bullion held in trust. ETFs that use swaps are exposed to counterparty risk—that is, the risk that the counterparty in the contract will no longer be able to meet its obligations. LEVERAGED EXCHANGE-TRADED FUNDS Like synthetic ETFs, leveraged ETFs use derivatives such as swaps to achieve the leveraged return. The portfolio transparency of leveraged ETFs is similar to that displayed in synthetic ETFs. A leveraged ETF is designed to achieve returns that are multiples of the performance of the underlying index they track. The use of leverage, or borrowed capital, makes them more sensitive to market movements. The fund uses borrowed capital, in addition to investor equity, to provide a higher level of exposure to the underlying index. Typically, a leveraged ETF uses $2 of leverage for every $1 of investor capital. The goal is to generate a return from the borrowed capital that exceeds what it cost to acquire the capital itself. For example, a leveraged ETF might attempt to achieve a daily return that is two times the daily return of the S&P 500. The challenge with these structures is that they are path dependent, which means that longer holding periods can create differences between an expected and realized return. EXAMPLE An example of a leveraged ETF is the ProShares Ultra S&P500, which attempts to deliver daily investment results that correspond to twice the daily performance of the S&P 500. INVERSE EXCHANGE-TRADED FUNDS Inverse ETFs can be constructed with derivatives such as swaps to achieve an inverse return effect. For example, an ETF could be based on a $300 million value swap referenced to the S&P 500. The swap could have a 10-year term, during which time the ETF sponsor makes periodic fixed payments in return for variable payments received every time the S&P 500 declines. The portfolio transparency is similar to that displayed in leveraged and synthetic ETFs. Inverse ETFs can be either leveraged or unleveraged. EXAMPLE An example of an inverse ETF is the Horizons BetaPro S&P/TSX 60 Inverse ETF that seeks to replicate, net of expenses, the inverse daily performance of the S&P/TSX 60 Index. ETFs that offer leverage or that are designed to perform inversely to the index or benchmark they track, or both, are highly complex financial instruments. They are typically designed for trading during the day. Because of the effects of compounding, their performance over longer periods can differ significantly from their stated daily objective. Therefore, leveraged and inverse ETFs that are reset daily are typically unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets. COMMODITY EXCHANGE-TRADED FUNDS There are three types of commodity ETFs: physical-based, futures-based, and equity-based. Below is a brief description of these three types. Physical-based ETFs Physical-based ETFs invest in the commodity directly. They are limited to only a few storable, non-perishable commodities, such as gold and silver. This structure has the benefit of closely matching the spot price (the price at which a commodity is bought or sold for immediate payment and delivery). © CANADIAN SECURITIES INSTITUTE  CHAPTER 19      EXCHANGE-TRADED FUNDS 19 13 Futures-based ETFs Futures-based ETFs invests in futures contracts of different commodities, with an underlying portfolio of money market instruments to cover the full value of the contracts. As near-term contracts approach expiration, they are rolled over into more distant contracts. In a normal market, rolling over the contracts can result in roll yield loss (the loss that results when a near-term futures contract approaches expiration and is rolled over into a more distant contract). Equity-based ETFs Equity-based ETFs invest in listed companies that are involved in exploration and development, or in the processing or refining of a commodity. Each type offers exposure to the respective commodity; however, they all present challenges in providing access to the spot price of a commodity. Commodity-based equities, and the ETFs based on them, often are not great proxies for the underlying commodity price because of factors that affect corporate performance and the general movement of the stock market. DID YOU KNOW? In a normal futures market (called a contango market), the distant contracts are priced higher to reflect the underlying commodities’ cost of carry. This is why rolling over the contracts in a contango market can result in a roll yield loss. By having to continuously buy futures contracts that are consistently priced higher than the spot price, the ETF is essentially locking in a small loss every time it rolls its futures positions. This loss affects the performance of the ETF, although less explicitly than the costs incurred by physically holding the commodity. Physical holdings in a commodity ETF are quite transparent; they simply have commodity holdings in designated warehouses and vaults. The transparency of securities holdings in a commodity ETF using derivatives depends on the type of replication the ETF sponsor is using. Visibility is clear if the ETF uses exchange-traded futures. It is less clear if the ETF portfolio uses a complex set of over-the-counter derivatives. EXAMPLE An example of a commodity ETF that is based on the physical holding of a commodity is the State Street’s SPDR Gold Shares ETF. The underlying assets consist of gold bullion stored in secure vaults. As such, the price of this ETF can be expected to move in lockstep with spot gold prices. COVERED CALL EXCHANGE-TRADED FUNDS Covered call ETFs employ strategies that have long been used by individual investors who have direct access to the equity and option markets. These strategies enhance the yield and reduce the volatility of owning the underlying stock or portfolio of stocks the options are applied against. DID YOU KNOW? As we discussed in Volume I of this course, a covered call option strategy, also known as a buy–write strategy, is implemented by writing (selling) a call option contract while owning an equivalent number of shares of the underlying stock. By writing a call against an underlying position, the investor would have to sell the stock, if it is assigned by the call buyer, when the market price rises above the call’s strike price. The covered call writer is, in effect, forgoing the opportunity to participate in the stock’s price appreciation over the exercise price. In return, the investor receives a premium, which provides some extra income and downside price protection. © CANADIAN SECURITIES INSTITUTE 19 14 CANADIAN SECURITIES COURSE      VOLUME 2 One advantage to accessing covered call strategies through an ETF (rather than directly) is having a team of professionals look after the investments. Another advantage is that managed products can engage in continuous application of covered call strategies. Therefore, the portfolio manager can write calls as often as needed and then later decide what to do with these contracts. When choosing a particular type of covered call ETF, you need to consider several issues. Management Depending on the mandate of the product, there can be constraints on the portfolio constraints manager that reflect the type of strategy the product is focusing on. For example, the manager may be constrained to using only at-the-money or out-of-the-money approaches, as well as percentage written. However, the portfolio manager, at his or her discretion, may from time to time write covered call options on a greater or lesser percentage of the portfolio. This gives the portfolio manager the flexibility to respond to changing market conditions. An understanding of the various types of constraints provides insight into the possible performance of the strategy in upward, downward, and range-bound markets. Fixed versus variable A fixed payment provides a consistent cash flow to the investor but can at times payments deplete capital if the sources of the fund’s yield (dividends and option premium) are not sufficient to cover the payment. A variable payment preserves principal, but payments can vary significantly, depending on market conditions and the strategy executed. It is usually preferable to avoid depleting principal over time, so investors should look for managed covered call strategies that pay a sustainable distribution. Fees Covered call ETFs generally have higher MERs and particularly higher trading expense ratios, in comparison to other types of ETFs. However, in terms of the costs of directly dealing in covered calls (e.g., bid/ask spreads and commissions), ETFs are price competitive. EXAMPLE An example of a covered call ETF is the BMO Covered Call Canadian Banks ETF, which has been designed to provide exposure to a portfolio of Canadian banks while earning call option premiums. The ETF invests in securities of Canadian banks and dynamically writes covered call options. The call options are written out-of-the- money and are selected based on analysis of the option’s implied volatility. The option premium provides limited downside protection. THE RISKS OF INVESTING IN EXCHANGE-TRADED FUNDS 4 | Identify and explain the risks specific to ETFs. ETFs are useful and versatile securities that offer investors many benefits. There are, however, some risks to consider with certain types of ETFs. There are three different categories of risk to consider: general investing risks; risks that are specific to ETFs; and risks specific to ETFs that use derivatives, leverage, or commodities, whether alone or in combination. DID YOU KNOW? General risks that investors face include inflation rate risk, interest rate risk, business risk, political risk, foreign investment risk, and risks based on liquidity and default. © CANADIAN SECURITIES INSTITUTE  CHAPTER 19      EXCHANGE-TRADED FUNDS 19 15 General investment risks are a concern for investors in all types of securities, including mutual funds and ETFs. However, the following types are some of the risks that are specific to ETFs: Risk related to tracking error Concentration risk Risk related to the composition of the ETF Risk related to securities lending RISK RELATED TO TRACKING ERROR For ETFs, tracking error is usually defined as the simple difference between the return on the underlying index or reference asset and the return on the ETF. Tracking error can be positive or negative, but it is most often negative. In other words, the return on the ETF is often lower than the return on the underlying index or reference asset. EXAMPLE Last year, the return on an ETF linked to the S&P/TSX 60 Index was 8.5%, whereas the return on the S&P/TSX 60 Index itself was 8.75%. The ETF’s tracking error in this case was 0.25%, or 25 basis points. Tracking error is an important consideration for ETF investors because their purpose in investing in ETFs is to get the return on the underlying index or reference asset. All else being equal, a return as close as possible to the return on the underlying index or reference asset is preferred over one that is substantially above or below that return. Tracking error on ETFs is generally lower in comparison to mutual funds because most ETFs are index-based. Also, the in-kind creation and redemption mechanism of ETFs keeps their prices very close to fair value. However, there is still a risk of tracking error, particularly with niche ETFs, for the reasons described below. FEES AND EXPENSES The most obvious source of tracking error is the ETF’s fees and expenses, including management fees, trading expenses, and operational expenses such as legal and accounting fees. The indexes that ETFs track do not have fees and expenses associated with them. An ETF should therefore be expected to underperform its underlying index or reference asset by at least the percentage of the fund that goes toward these items. Fees and expenses are generally significantly less than those of mutual funds. SAMPLING METHODS Most equity index ETFs hold the shares of the index they are replicating. Some, however, particularly bond index ETFs, do not buy every security in the index. Instead, they invest in a subset of the index that the manager chooses as a representative sample. The aim of sampling is to give the ETF a return as close as possible to the return on the underlying index or reference asset. Naturally, there is greater tracking error risk with ETFs that use a sampling approach. LIQUIDITY The illiquidity of certain sectors of the fixed-income market makes it difficult for the creation and redemption process to keep the NAV close to its true value in a timely manner. Many bonds trade only a few times a day or week, and the number of bonds available in the open market diminishes as one goes down the credit scale or up in maturity. For these reasons, it can be difficult for institutional investors to trade size at a reasonable price. For example, a bond ETF based on federal or provincial government debt can have a tighter NAV than an ETF based on a corporate bond index. © CANADIAN SECURITIES INSTITUTE 19 16 CANADIAN SECURITIES COURSE      VOLUME 2 CASH DRAG Cash drag occurs when a fund is not fully invested in the underlying index or reference asset it is tracking. As a result, the fund’s performance may trail that of the underlying index or reference asset. This risk is more pronounced with mutual funds, where time may be needed to work new money into the market. Mutual funds also tend to keep some cash on hand to deal with requests for redemptions. By comparison, most ETFs are fully invested and thus do not generally have much cash drag, if any. With the innovations in ETFs, however, it is possible that some will not have fully invested in the reference asset or underlying index. In these cases, ETFs may hold cash for dividend or interest payments, or for trading activity. While the ETF holds the cash, the reference asset or underlying index moves along as usual, and the ETF trails its performance. REBALANCING Indexes are occasionally rebalanced as existing securities are taken out of the index and new ones are added. As well, weightings get changed frequently. It is relatively simple to instantaneously rebalance a hypothetical index, but ETFs must actually go out into the market and buy and sell securities. Although this process is largely automated, tracking error arises when an ETF is unable to execute at the identical time and price as the index. One way to minimize this type of tracking error is to focus on ETFs linked to indexes that require minimal rebalancing—specifically, market capitalization-weighted products. Equal-weighted indexes must rebalance much more frequently to give an equal allocation to each component security. CURRENCY HEDGING Some ETFs that invest in non-Canadian assets hedge the currency risk by taking an offsetting short position in the foreign currency to match the dollar amount of the underlying asset. If the underlying foreign currency depreciates in value against the Canadian dollar, the performance of the ETF will suffer, in Canadian dollar terms. However, these losses can be offset by the gain in the short foreign currency position. Conversely, if the foreign currency appreciates (which would otherwise help the performance of the ETF in Canadian dollar terms), these gains can be offset by the loss in the short foreign currency position. Either way, the ETF investor is protected from currency fluctuations. As a result, the investment performance is almost solely based on the underlying asset. Currency hedging is done monthly, with no hedging of the market growth or depreciation of the underlying asset during the month. A small amount of currency risk results. Also, there is a minimal cost for the hedge. Between these two factors, a small amount of tracking error can occur, compared to the reference asset. CONCENTRATION RISK Concentration risk in an ETF occurs when a small number of holdings make up a disproportionate amount of the overall ETF value. In such cases, the ETF and underlying index on which it is based become more sensitive to moves in just a few stocks. As a result, the diversification sought by an investor decreases and the unsystematic risk increases. Both ETFs and mutual funds are prohibited from having more than 10% of their funds invested in the securities of one issuer. However, this regulatory restriction in concentration does not apply to index-based funds because it would keep the fund from attaining its investment objectives of matching the index. Because the restriction largely affects actively managed ETFs or mutual funds, concentration risk is not a concern for investors with these types of funds. It is, however, a concern for ETF index funds, particularly those funds that are focused on an index with a small number of components. These funds typically have concentration limits, but they may be considerably higher than the 10% regulatory limit. When concentration risk is evident in an ETF, you should consider whether it might be more efficient to buy the individual securities held in the ETF instead. © CANADIAN SECURITIES INSTITUTE  CHAPTER 19      EXCHANGE-TRADED FUNDS 19 17 RISK RELATED TO THE COMPOSITION OF THE EXCHANGE-TRADED FUND Before recommending the purchase of ETFs to your clients, you must clearly understand the funds. Otherwise, your clients’ expectations can diverge significantly from the market performance. With thousands of ETFs available on the market, different ETFs can represent different components of the market— even different components of an individual sector. For example, although there are numerous different China ETFs to choose from, some represent a narrow index of stocks while others represent a broader index. Some ETFs even trade on the basis of the same underlying stocks that comprise a particular index. However, they may use different weighting methodologies, causing their performance to differ significantly from the standard index. EXAMPLE Composition Risk The RWL ETF is made up of the same equities found in the S&P 500 Index, but the holdings are weighted according to top-line revenue, rather than market capitalization. This different approach to weighting can produce very different results in performance. DID YOU KNOW? While a company’s bottom line refers to its net income, top-line revenue refers to a company’s gross revenue or sales. RISK RELATED TO SECURITIES LENDING Securities lending refers to extending a loan of stocks for a fee, with the aim of earning additional income for unitholders to partially offset fund fees. Many equity ETFs are active in the securities lending business. These ETFs lend their shareholdings to investors who wish to short sell certain equity issues. Short sellers may range from small retail investors to large hedge funds. The risk of securities lending comes from the creditworthiness of the money market securities bought and received and the default risk of the share borrower. In 2007 and 2008, a liquidity crisis in the credit markets emerged as seemingly solid bond issuers defaulted on their obligations. To avoid their own liquidity crises, ETFs should set minimum credit guidelines for the short-term securities that ultimately serve as collateral. Each ETF issuer has its own approach to conducting securities lending. NI 81-102 rules dictate that a maximum of 50% of a mutual fund trust NAV can be on loan at any time. The amount lent out varies depending on the ETF issuer and on the product. The average utilization rate of a large cap Canadian equity or broad fixed-income fund is less than 5%. As part of a due diligence review of an ETF issuer, you need to understand the specific details of the approach to determine whether it is acceptable, and consider the following factors: Does the provider use a third-party securities lending agent? If investment lending is not a specialty of the firm, the use of a lending agent adds value. Where is the revenue from securities lending directed, and how much is directed back to the fund? Does the ETF issuer retain a portion of lending revenue? What type of collateral is required, and how far above the 102% minimum required by regulation does it reach? What type of minimum credit guidelines are set for the short-term securities that ultimately serve as collateral? Are there any special exemptions to the rules for fund-of-funds lending? The overall exposure to the risk of securities lending can be higher in this case. © CANADIAN SECURITIES INSTITUTE 19 18 CANADIAN SECURITIES COURSE      VOLUME 2 COMPARING EXCHANGE-TRADED FUNDS AND MUTUAL FUNDS 5 | Compare and contrast ETFs and mutual funds. In comparing ETFs and mutual funds, you should consider management style, transparency of holdings, and costs arising from embedded fees and advisor compensation, among many other factors. Table 19.1 provides a comparison of the various features of the two types of funds. Table 19.1 | Comparing Exchange-Traded Funds and Mutual Funds Category Exchange-Traded Funds Mutual Funds Management Style They consist mainly of passive funds, They consist of mainly active funds, with some active funds. with some passive funds. Transparency Most ETFs provide full transparency. Most mutual funds limit disclosure of holdings to once a month; typically focusing on the top 10 holdings. Cash drag flow They can handle large infusions of cash They need time to work new money management without suffering from cash drag. into the market and tend to keep some cash on hand to fulfill redemption requests. Embedded fees Management and trading expenses Management and trading expenses tend to be lower because most funds tend to be higher because most funds are passive. are active. Advisor compensation The client pays a commission to the In addition to load charges, investors dealer. The vast majority of ETFs do not may have an embedded compensation provide trailer fees for the advisor. for the advisors, which is part of the MER. An exception is the F Class version of mutual funds. Distribution They are bought and sold like stocks They are purchased and redeemed in the secondary market during the directly from the mutual fund at trading day. In some circumstances, the end-of-day’s NAV per unit. ETFs can trade at a significant premium This is considered a primary market or discount to the NAV. transaction, because units go directly between the investor and the mutual fund. Mutual funds do not trade at a premium or discount. Tradability They can be held in a margin account They can be held in a margin account. and sold short. ETFs trade throughout Mutual funds cannot be sold short, do the day and investors can use special not trade during the trading day, and orders such as limit and stop loss special trading rules do not apply. orders. Minimum investment ETFs can be purchased in single units Mutual funds can be acquired for as (though the spread may be slightly little as $500. higher). © CANADIAN SECURITIES INSTITUTE  CHAPTER 19      EXCHANGE-TRADED FUNDS 19 19 Table 19.1 | Comparing Exchange-Traded Funds and Mutual Funds Category Exchange-Traded Funds Mutual Funds Pre-authorized Only a few ETFs offer PACs and SWPs. Most mutual funds offer PACs and contributions (PACs) and Most ETFs allow only full units to be SWPs. Mutual funds can buy and sell systematic withdrawal purchased or redeemed, which makes partial units, and so a regular dollar plans (SWPs) it harder to set the specific dollar value value can be easily set. for PACs and SWPs. Dividend reinvestment Only some ETFs offer dividend Most mutual funds offer a dividend reinvestment plans. Where offered, reinvestment plan. The purchase of the reinvestment must be made in full partial units is common. units. Liquidity The volume traded on an ETF is not a Mutual funds simply trade at the end measure of liquidity. ETFs are simply a of the day at the NAVPU of the fund. basket of securities. If the underlying securities are liquid, then so is the ETF. Tax efficiency They are more tax efficient because of They are less tax efficient because the lower portfolio turnover. of the higher portfolio turnover. Redemption of units might trigger capital gains if enough investors redeem units, forcing the manager to sell off securities to raise cash. Tracking error There is a potential for tracking error, There is a potential for tracking error, but ETFs generally have the lower risk. and mutual funds generally have the higher risk. TAXATION OF INVESTORS IN EXCHANGE-TRADED FUNDS 6 | Summarize the taxation impacts of investing in ETFs. Investors holding an ETF in a non-registered, taxable account may be taxed in two ways: on distributions from the ETF fund and on the proceeds of a sale of the ETF. DISTRIBUTIONS Distributions from ETFs can be classified under the following three categories: Dividend and interest distributions Capital gains distributions Non-taxable distributions These three different categories are briefly described below. © CANADIAN SECURITIES INSTITUTE 19 20 CANADIAN SECURITIES COURSE      VOLUME 2 DIVIDEND AND INTEREST DISTRIBUTIONS The individual shares held within an equity ETF pay dividends that are received by the ETF. Similarly, fixed-income ETFs receive interest on their investments in bonds and other debt obligations. Distributions by the ETFs to investors out of the ETF’s dividend and interest income, net of fees, are generally treated as ordinary income to the investors. However, if the ETF pays a distribution out of dividends received from Canadian companies, investors can treat that distribution as if it were a dividend from a Canadian company. For Canadian residents, distributions from Canadian companies qualify for a lower effective tax rate than those of non-Canadian companies. Distributions from an ETF are typically paid in cash, either monthly, quarterly, or annually. Generally, the greater the income generated in the fund, the higher the distribution frequency. CAPITAL GAINS DISTRIBUTIONS The following two factors determine the size of any ETF’s capital gains distribution in a given year: The net of the fund’s current capital gains, less any capital losses, plus specific gain allocations (e.g., to a specific institutional investor) Any amount from the Capital Gains Refund Mechanism (CGRM), a method recognized by the Income Tax Act that gives preferential treatment to capital gains generated by redemptions DID YOU KNOW? The CGRM is a formula devised to prevent double taxation of capital gains in a mutual fund or ETF. Typically, when a fund sells investments that it holds, any accrued capital gains flow through to the investors and are taxed in their hands. The CGRM is based on the recognition that those gains can be subject to taxation twice over as follows: Once when investors redeeming their units realize a taxable capital gain Again, when the fund sells investments to cover the cost of the redemptions, thus also realizing a taxable capital gain The CGRM allows the fund to retain some of its realized gains generated by redemptions, rather than distributing them to investors. The fund does not pay tax on those gains in that taxation year. In most cases, it is more efficient for an ETF to distribute its realized capital gains by issuing more units, rather than by paying a cash distribution. At year end, the ETF issues new units to its investors that have a value equal to the amount of the capital gains distribution. It then immediately consolidates its units, so that Canadian resident investors hold the same number of units as they did before the distribution. This process is generally known as reinvested phantom distributions (or, reinvested capital gains distributions). This type of capital gains distribution is still taxable to investors in the same way as a cash distribution. However, the investors’ adjusted cost base (ACB) of their units is increased by the amount of this in-kind distribution. If the investor were to sell the ETF units, the higher ACB would reduce the amount of any capital gain they would otherwise realize on the sale. NON-TAXABLE DISTRIBUTIONS In some cases, an ETF may distribute an amount that is not taxable to the investors, such as a return of invested capital (ROC), for example. However, such a distribution decreases the ACB of the investor’s units. If the investor were to sell the ETF units, the lower ACB would increase the amount of any capital gain that would otherwise be realized on the sale. For example, accounting methods, combined with market conditions, may transform some of the yield paid out to be classified as ROC. This could happen even if the product provider pays only a sustainable distribution. Such © CANADIAN SECURITIES INSTITUTE  CHAPTER 19      EXCHANGE-TRADED FUNDS 19 21 instances are common to any pooled investment where the unitholder base fluctuates over time. This fluctuation makes it impossible to accurately link revenue earned from dividends and income to a changing number of investors. This consideration generally applies to the ETF industry as a function of fund growth. An ETF aims to maintain a payout close to the index or market payout, net of fees. When it receives a subscription, it receives the cash component equal to the outstanding income on the fund, in addition to the basket of securities that represent the portfolio. The ETF then pays out the cash components received as part of its distribution to maintain the ETF’s yield. This payout results in a small amount of beneficial ROC. PURCHASE AND SALE OF EXCHANGE-TRADED FUNDS As with any security held by an investor, there are tax implications to buying and then selling an ETF. A capital gain occurs when the ETF is sold for more than its ACB, net of any selling costs such as commissions. Of these gains, 50% is taxable. As discussed earlier, any in-kind capital gains distribution that the ETF investor receives increases that investor’s ACB by the amount of the distribution. This adjustment may be handled by the dealer member where the investor’s account is held. The capital gain distribution, by adding to the investor’s ACB, results in a lower capital gain when the ETF is sold. A capital loss is generated when the ETF is sold for less than its ACB. Capital losses can be deducted from capital gains in the same taxation year, carried back three years to be applied against gains, or carried forward indefinitely. INVESTMENT STRATEGIES USING EXCHANGE-TRADED FUNDS 7 | Identify the investment strategies involving ETFs. In addition to their general uses, such as diversification and targeted exposure, ETFs can play more complex roles in an investment portfolio. When using ETFs to implement investment strategies, you should also consider the specific trading characteristics of these securities. TIPS FOR TRADING EXCHANGE-TRADED FUNDS When placing trades in ETFs, consider the following general trading tips: Use limit orders to attain free protection from sudden price movements. For large trades, place large portions of the trade at once, so that the designated broker understands the need to create new ETFs to meet the demand. Unlike stocks, where a large trade can be executed in small portions at a time, there is limited advantage to doing this for an ETF trade. Avoid trading ETFs when the market for their underlying securities is closed. For example, European and global ETFs should be traded in the morning, while European markets are open. East Asian and emerging markets ETFs are difficult in this respect because most major global markets are closed during North American trading hours, except for Latin American markets. Be careful when trading in ETFs where any major underlying holding is halted based on news or a corporate action. In such situations, spreads tend to widen. © CANADIAN SECURITIES INSTITUTE 19 22 CANADIAN SECURITIES COURSE      VOLUME 2 MORE COMPLEX EXCHANGE-TRADED FUND ROLES Table 19.2 provides a brief introduction to some of the more complex roles that ETFs can play in an investment portfolio. Table 19.2 | Investment Strategies Using Exchange-Traded Funds Strategy Purpose Core and satellite Core holdings are typically passive ETF holdings intended to provide the majority of portfolio construction returns; satellite holdings are more focused on riskier sector ETF holdings. Satellite holdings are used to boost returns above the core asset returns. Rebalancing ETFs can provide a simple and liquid way to rebalance the asset allocation without affecting the core portfolio holdings. A small allocation to domestic and international equity and fixed-income ETFs provides an efficient way to rebalance across the asset class when needed. Tactical asset Investment managers can use ETFs as a tool to gain quick, diversified exposure to the allocation targeted asset class, while instantly exiting the previous holding. With today’s vast choice of ETFs, investors and advisors can use them as the primary tool to implement tactical shifts in a portfolio. Cash management ETFs allow investors to temporarily park their money in the stock market until they make a long-term investment decision. Exposure to once With ETFs having expanded into offering hard-to-access classes, new levels of portfolio hard-to-access optimization have become available. markets Tax loss harvesting ETFs are useful in harvesting tax losses on an investment; they can be used to maintain exposure to a sector while respecting Canada Revenue Agency’s superficial loss rules. As long as the ETF purchased is not identical to an asset sold, the ETF can be used as a substitute for the asset. (Superficial loss rules are covered in a later chapter in this course.) OTHER RELATED PRODUCTS 8 | Define mutual funds of ETFs and exchange-traded notes (ETNs). In this section, we briefly discuss two other types of ETF structure. MUTUAL FUNDS OF ETFs A type of mutual fund that holds a portfolio of ETFs (rather than stocks and bonds) has emerged, and many such funds are now offered. Combining the benefits of mutual funds and ETFs, mutual funds of ETFs make up one of the fastest growing segments within the mutual fund industry. They have the benefit of PACs and SWPs, in addition to advisor compensation options that are standard with most mutual fund offerings. The advisor compensation does reflect a higher cost than with ETFs. However, these products tend to average 0.5% lower in MER than traditional mutual funds, which represents a significant cost savings. © CANADIAN SECURITIES INSTITUTE  CHAPTER 19      EXCHANGE-TRADED FUNDS 19 23 With a number of ETFs packaged into one investment vehicle, the investor has the benefit of automatic rebalancing without the costs of trading the ETF. These portfolios can be static, where the asset mix is held consistent, or tactical, where the portfolio manager selects the ETF holdings based on personal preference. EXCHANGE-TRADED NOTES Some investors and advisors confuse exchange-traded notes (ETN) with ETFs. They do have some similarities. For example, they both trade on an exchange and they both give investors exposure to an underlying asset. However, they are very different investment vehicles. ETNs are not investment funds—they are debt obligations issued by a bank. These securities promise to pay investors a return on their investment based on the performance of an index or other benchmark. In exchange for the guarantee of delivering the total return of the underlying asset, ETNs charge an annual fee. Unlike ETFs, ETNs do not have tracking error risk because of the above guarantee—the bank issuing them promises to pay a return based on the underlying asset. However, the bank does not guarantee investment performance. If the underlying asset decreases in value, so will the ETN. Another major difference from ETFs is that ETNs face credit risk—that is, the risk that the issuer will default on the note or that the market price of the ETN dislocates from the NAV because of increased credit risk concerns regarding the issuer. ETFs do have some counterparty credit risk, if they are synthetically constructed. Finally, ETNs can face call or early redemption risk from the issuer, which may adversely impact the ETNs’ value. OVERVIEW OF ETFs AND ETF FEATURES AND TYPES Can you identify some of the features and types of exchange-traded funds and explain how they compare to other types of investments? Complete the online learning activity to assess your knowledge. CASE SCENARIO Can you answer Tariq’s questions about ETFs and mutual funds? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 19 24 CANADIAN SECURITIES COURSE      VOLUME 2 SUMMARY In this chapter, we discussed the following key aspects of ETFs: ETFs are regulated under either of two national instruments, depending on their structure: NI 81-102, which limits the use of leverage and derivatives; and NI 81-104, which allows for more aggressive strategies. ETFs must produce and file an ETF Facts document addressing trading and pricing characteristics. The ETF creation and redemption process involves the designated broker buying and selling ETF units and exchanging them with the ETF provider for the ETF’s underlying securities. This process, which can also work in reverse, is known as an in-kind exchange because a basket of stocks is exchanged for ETF units, rather than cash. Investors benefit from lower trading costs and lower taxes. The following ETFs are a few of the various types available on the market: Standard (index-based), whereby the reference index on which the ETF is based can be either fully replicated or approximately constructed through sampling Rules-based, which are constructed based on a defined methodology to achieve a specific objective Synthetic, which are constructed with derivatives such as swaps to achieve the return effect of the index Leveraged, which use derivatives such as swaps to achieve the leveraged return The following risks are specific to ETFs, among others: Risk related to tracking error Concentration risk Risk related to the composition of the ETF Risk related to securities lending In comparing ETFs and mutual funds, you should consider management style, transparency of holdings, costs, liquidity, and tracking error, among other factors. For example, in comparison to mutual funds, ETFs tend towards more passive management, holdings tend to be more transparent, and tracking error is lower. Distributions from ETFs are classified as dividend and interest distributions, capital gains distributions, and non- taxable distributions. Distributions out of dividend and interest income are generally treated as taxable income to the investors. Two factors determine the size of an ETF’s capital gains distribution: The net of the fund’s current capital gains, less any capital losses, plus specific gain allocations Any amount from the CGRM, which reduces the tax paid on capital gains generated by redemptions Mutual funds of ETFs hold a portfolio of ETFs, rather than stocks or bonds, which give the benefit of automatic rebalancing without the costs of trading the ETF. They also offer PACs and SWPs. Advisor compensation reflects a higher cost than with ETFs, but lower than traditional mutual funds. ETNs differ from ETFs in several ways; they are debt obligations issued by a bank that promise, for an annual fee, to pay investors a return based on the performance of an index or other benchmark. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 19 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 19 FAQs. © CANADIAN SECURITIES INSTITUTE