This is the first of what will be a monthly series of informational posts, delivering overviews on important financial topics. These will be relevant for anyone taking a financial planning course.
We are starting off with Exchange-traded funds, the fastest growing investment products, in sales in Canada.
Exchange-traded funds (ETFs) are baskets of securities that are traded like individual stocks on an exchange. ETFs are similar to index mutual funds in that they primarily invest in the equities, bonds or basket of commodities, that comprise a target index. The way in which an ETF is structured allows it to be far more tax efficient and cost effective than the average index mutual fund.
ETFs issue their shares in large blocks known as creation units. Usually~ creation unit is a block of25,000 to 200,000 ETF shares that track the index. Investors, known as authorized participants, do not purchase creation units with cash. Instead, they exchange, on an in-kind basis, baskets of securities that mirror the index to acquire the units.
Why buy Exchange-Traded Funds?
There is no evidence that mutual fund managers, on average, outperform their benchmark index. In an Industry Review by BlackRock, entitled “ETF Landscape, Q1, 2011,” the authors quote statistics from Standard and Poors, based on Standard and Poor’s indices versus actively managed mutual funds as at mid 2010. In the US, over the last five years to mid year 2010, the S&P 500 index outperformed 63.7% of actively managed large-cap US equity funds; the S&P MidCap 400 outperformed 76.7% of mid-cap US equity mutual funds; and the S&P SmallCap 600 Index outperformed 65.2% of small-cap US equity mutual funds.
For fixed income mutual funds, over the same five year period, according to “ETF Landscape”, more than three quarters of active fixed income managers failed to beat their respective benchmarks.
Investing in ETFs typically represents passive investing in a market index. By passively investing in the stocks or bonds of a specific index, the investor on average would have higher returns. Also, with passively managed ETFs, management fees are much lower than that for mutual funds.
The ETF market began in Canada in 1990, with the introduction of Toronto Index Participation Shares (TIPS), based on the TSE (Toronto Stock Exchange) 35 index (now S&P/TSX 60 Index). As at May, 2011, assets under management (AUM) in ETFs internationally was close to $1.4 trillion, with slightly over $1 trillion in the US. As at May, 2011, the ETF market in Canada was approximately $41 billion (AUM). The largest sponsors of ETFs globally are: iShares, owned by BlackRock; State Street Global Advisors; and Vanguard. The three indices on which the ETFs are most widely based in terms of assets are: MSCI; S&P; and Barclay’s respectively. ETFs are currently trading on 18 exchanges, globally.
In Canada, there are several ETF sponsors including: BlackRock Asset Management Canada Ltd., iShares; Horizon Exchange Traded Funds; BMO Asset Management Inc.; Power Shares; and XTF Capital. BlackRock Asset Management Inc. recently offered to purchase Claymore Investments Inc. The ETF market in Canada has grown from $12.3 billion AUM on December 31st, 2005 to $40.8 billion as at mid-May, 2011. Over the previous five years, ETF assets under management in Canada has grown by 27% per year.
Authorized participants are usually institutional investors, specialists, or market-makers who have signed an agreement with and paid fees to a particular ETF sponsor. Becoming an authorized participant allows institutions to carry out direct in-kind transactions with the fund. After purchasing a creation unit, the authorized participant can split up and sell the individual shares of the unit on the open market. If small investors wish to buy units of the ETF, they can do so through brokers. The buying and selling of ETF units on the open market has no taxable effect on other ETF unitholders because the constituent securities are untouched.
Popular Exchange Traded Funds
In Canada the most popular ETF is offered by BlackRock and is the ishares S&P/TSX 60; symbol XIU. In the US, ETFs trade on the New York Stock Exchange and the American Stock Exchange. Amongst the largest ETFs in the US, are the GLD (Gold) ETF and the SPDR S&P 500 ETF. The SPDR ETFs are sponsored by State Street Global Advisors.
Other popular US ETFs include:
- DIAMONDS, which are based on the Dow Jones Industrial Average (DJIA). Diamonds offer an investment that has a return close to the return on the DJIA.
- NASDAQ-I 00 Index Tracking Stock ETF (commonly called “cubes” because of their trading symbol- QQQ).Cubes, based on the NADAQ 100 Index, offer an investment that has a return close to the return on the NASDAQ 100 Index.
- Select Sector SPDRs which are ETFs based on nine of the 10 sub-indexes of the S&P 500.
Relationship between ETF’s Net Asset Value, the Value of the Underlying Asset, and the ETF’s Trading Price
ETFs have a NAVPS, which, like other managed products, is equal to the total market value of the ETF’s assets minus the ETF’s total liabilities, divided by the number of units outstanding. For all equity-based ETFs, the NAVPS is designed to closely track the value of the underlying index.
The NA VPS indicates the approximate value of an ETF compared to its underlying index. Small deviations between the ETF’s net asset value and the underlying index may occur because:
- accrued dividends, if any, are held in the ETF and are distributed to unit holders on a quarterly basis; however, dividends do not accrue in the underlying index.
- an ETF has a small management expense ratio, whereas the underlying index does not.
Most ETFs trade at a price close to their net asset value per share. Because ETFs are exchange-traded instruments, their price is based on supply and demand and may deviate slightly from the net asset value per share. The deviation is usually small.
If there is a significant difference between an ETF’ s market price and its net asset value per share, a potential arbitrage opportunity would exist. This opportunity arises because with ETFs it is possible for authorized participants to obtain new units of the ETF directly from the ETF’s custodian, not for cash, but in exchange for a basket of stocks that represent the stocks in the underlying index. It is possible for authorized participants to do the reverse – dispose of ETF units directly to the custodian in exchange for the basket of stocks.
For example, assume that there is only one stock in an ETF index. If the underlying stock is traded at $20; and the ETF share trades at $19, the authorized participant could short the stock at $20, and buy the ETF share at $19. The authorized participant could then exchange the ETF share to get the stock to cover the short sale. This would result in a profit of$1.00 [+$20- $19]. Due to arbitrage, there would be significant shorting in the stock and buying in the ETF shares which should cause the stock price and ETF price to converge.
The Use of ETFs in a Client Portfolio
ETFs typically represent passive investments, because the underlying basket of securities is typically fixed. However, some ETFs do use active management. By purchasing an ETF, an investor gains exposure to the securities of a particular basket or index. What needs to be decided is the asset class or geographical diversification exposure required by the investor. ETFs are used by: investors following a passive investment strategy; and active investors who use an ETF to establish exposure to an index for a desired length of time.
l have included three questions on ETFs that you might want to challenge.
What is not correct about ETFs versus mutual funds?
a) ETFs are easier to trade
b) ETFs, unlike mutual funds, can be sold short
c) ETFs, like mutual funds, allow investors to buy or redeem the fund at the NA VPS, which in most cases is calculated every business day
d) ETFs typically have lower MERs, relative to comparable mutual funds.
In respect to the value of ETFs, which of the following statements are correct?
I. For all equity-based ETFs, the NAVPS is designed to closely track the value of the underlying index.
II. The NA VPS indicates the approximate value of an ETF compared to its underlying index. Small deviations between the ETF’s net asset value and the underlying index may occur because accrued dividends, if any, are held in the ETF and are distributed to unit holders on a quarterly basis; however, dividends do not accrue in the underlying index.
Ill. The NA VPS indicates the approximate value of an ETF compared to its underlying index. Small deviations between the ETF’ s net asset value and the underlying index may occur because an ETF has a small management expense ratio, whereas the underlying index does not.
IV. Because ETFs are exchanged-traded instruments, their price is based on supply and demand and may deviate slightly from the net asset value per share.
a) I, II
b) III, IV
c) I, II, Ill
d) I, II, III, IV
What is correct about leveraged ETFs?
I. A leveraged ETF is designed to achieve returns that are multiples of the performance of the underlying index it tracks.
II. The use of leverage, or borrowed capital, makes the ETF 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.
III. Typically, a leveraged ETF will use $3 of leverage for every $1 of investor capital.
IV. The goal is to generate a return made with the borrowed capital that exceeds what it costs to acquire the capital itself. For example, a leveraged ETF, based on the S&P 500 Index, might attempt to achieve a daily return that is three times the daily return of the S&P 500.
a) I, II, III
b) I, II
c) I, II, IV
d) I, II, III, IV
The answers to the questions on ETFs will be posted 1 week from today, Friday July 5
Edit: Answers can now be found here.
Good luck on your studies.