Market Buzz – ETFs 101 – Using Exchange Traded Funds (ETFs) to Enhance Your Portfolio
Exchange Traded Funds or ETFs are a highly versatile investment product that every active investor should make themselves fully aware of. They operate much like mutual funds in that they pool capital together to build a portfolio that is invested with specific objectives. Each investor owns a share of the fund and can redeem or sell units when they request. As a relatively new investment product, ETFs are designed to track (generate an identical return) to specific market sectors and indexes. You can buy an ETF that tracks the overall market in Canada, the market in a foreign country like China or India, a specific sector like technology or mining, or a commodity like gold or oil. Unlike mutual funds, ETFs trade like stocks, so instead of buying and redeeming a unit at its net asset value (as with mutual funds), you buy units at a price based on supply and demand, which can be above or below net asset value (but is usually fairly close).
So say you decide that you want to gain exposure to the investment returns in an emerging market like China. First of all, foreigners are forbidden to purchase a company trading on the Shanghai Stock Exchange (SEE), and even if they weren’t, where would you start? No problem, just purchase one of the several ETFs that track the index. What if you want to gain exposure to gold? You’re not naïve enough buy bullion that is stored in the Cayman Islands and you don’t have the time or the industry knowledge to start researching a bunch of gold miners. Just buy the ETF.
Passive Investing versus Active Investing
One of the most important decisions that a portfolio manager must make (whether it be a professional portfolio manager or a private individual managing their own portfolio) is whether to invest actively or passively. Active investors spend time researching investments in order to outperform the market, whereas passive investors either don’t believe it is possible to outperform the market or just don’t want to spend the required time. The passive investor simply wishes to generate a return that mimics the overall market return. One of the key differences between mutual funds and ETFs is that the vast majority of mutual funds are actively managed while nearly all ETFs (with only a few exceptions) are passively managed.
The main argument for passive investing over active investing is that over 80% of actively managed mutual funds do not outperform the market over time. Even though you are paying professional managers a hefty fee (averaging about 2% of invested assets) to generate superior returns to the market, statistically most will be unsuccessful in doing. This does not mean that you should only invest passively; there are numerous examples of skilled money managers who have generated superior returns for clients in up and down markets. However, if you are simply relying on some cookie cutter, Large-Cap mutual fund to do the job, you will probably end up disappointed; and you will be even more disappointed to find out that you paid your manager 2% + of your total invested assets to underperform a passive fund that only charges 0.5%.
The good news is you don’t necessarily have to choose between active and passive investing. There is a third choice, the hybrid approach, where you allocate a portion of your portfolio to passive investing and a portion to active investing. The hybrid investor recognizes that opportunities do exist to find undervalued investments that offer the potential for higher returns. But this investor also recognizes that investing actively also carries additional risk, requires an investment of time, and that good undervalued opportunities are not always plentiful. The exact allocation would depend on the characteristics of the investor. An investor that makes the 20%/80% between passive and active investing has a high level of confidence in either themselves or their manager to outperform the market. The investor that makes the 80%/20% allocation has substantially less confidence in the active strategy, but does not want to miss out on rare opportunity to make a great investment.
Passive Mutual Funds (Index Funds) versus ETFs
Although the majority of mutual funds are actively managed, there are also some passively managed vehicles which are referred to as index funds. Much like ETFs, index funds attempt to mimic the return of the overall market index, specific sectors or even commodities. We are not averse to investing in index funds; in fact we adamantly support them as an alternative to investing in actively managed mutual funds. In trust, there are several pros and cons with regard to investing in ETFs as opposed to index funds. One favourable characteristic that is unique to ETFs is the ‘in kind’ redemption which provides tax deferral for unit holders. When an index fund sells stock to fulfill redemption requests, the capital gain tax liability is spread amongst the unit holders, regardless of whether or not they are redeeming. Investors in ETFs can realize return by either selling their units on the open market or by exercising the ‘in kind’ redemption, whereby they would receive a basket of securities proportional to the units they are redeeming. In either instance, no tax liability is incurred by investors who are not redeeming units. For the investor that redeemed ‘in kind’, tax liability would only be incurred if they sell from the basket of securities they received (assuming there is a capital gain of course).
Understanding Discounts and Premiums
Because ETFs trade like stocks, their prices often hover above or below the net asset value contained within the fund. If the ETF is selling for more than its net asset value, it is trading at a premium, if it is selling for less, it is trading at a discount. There are a number justifiable reasons that if the premium or discount is small, then its impact should be minimal, but in some cases the difference could be significant and it can affect the return on your investment. A good example would be an ETF that tracks the return of a foreign country that restricts foreign investment. This ETF will typically trade at a premium to net asset value because it is one of the few methods that can be used to access this market. If however, the government of this foreign entity decides to loosen the restrictions on foreign investment, then the premium is likely to decline significantly and so is the value of your investment. This is a single example of how premiums and discounts on ETFs work. While I don’t suggest you try to speculate on the movement of the premium (which defeats the purpose of ETFs), it is important that you understand how it can affect your return.
How to Buy ETFs
A great thing about ETFs is that they are extremely easy to buy and sell. They trade on an exchange and like any stock, they can be purchased through a discount brokerage. You simply need to decide what ETFs you want to buy, get the trading symbol, and enter your limit order with your discount broker. Two institutions that offer ETFs in Canada are iShares (www.ishares.com) and Claymore Investments (www.claymoreinvestments.ca). You can also find additional information on ETFs at Yahoo Finance Canada (www.ca.yahoo.finance.com/etf) and Globeinvestor (www.globeinvestor.com/v5/content/etf_hub/).
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