ETFs and Index Investing

While definitions will vary slightly and some are more detailed than others, I define Exchange Traded Funds (ETFs) this way:

an investment product that acts like a stock but also like a mutual fund that can be bought and sold on a stock exchange.

Examples of organizations that provide ETFs include:

• iShares. Managed by BlackRock Asset Management Canada Limited, iShares are the largest ETF provider in the world, with more than 350 funds; over US$300 billion in assets under management and with almost 50% of the worldwide ETF market share.

• Claymore Investments, Inc. Claymore Investments, Inc. is the wholly-owned Canadian subsidiary of Claymore Group, Inc, a U.S. entity. In total, Claymore entities oversee about $10.4 billion in assets.

• Horizons AlphaPro ETFs. Canada’s only family of actively managed ETFs, managed by AlphaPro Management Inc., a subsidiary of BetaPro Management Inc.

• Horizons BetaPro ETFs. Canada’s sole provider of leveraged and inverse leveraged ETFs.

• BMO Exchange Traded Funds. Offered by Jones Heward Investment Counsel Inc., a member of BMO Financial Group family, under the umbrella structure of BMO Asset Management.

• Barclays Capital. Barclays is the investment banking division of Barclays Bank PLC.

While ETFs may get kicked around for being boring, I see beyond the naysayers (mostly mutual fund managers charging high fees for their mutual fund products) and look to all the great things ETFs offer me as an individual investor – especially when they track a broad market index. 

1. Excellent transparency. ETFs disclose their exact holdings so I always understand precisely what I own (or am buying). You might get to see the top-10 holdings for most mutual funds, if you’re lucky.

2. Superior flexibility. ETFs can be bought and sold at any time when the exchange is open, using limit or stop orders just like stocks, through my discount brokerage account. I can purchase the index I want to follow with one simple transaction – say the DEX Universe Bond Index. Traditional mutual funds are priced at the end of the day so I have less control over the price I want to pay upon making the transaction.

3. Tax efficiency. ETFs typically have lower portfolio turnover because indexes rarely change. Low ETF turnover limits capital gains distributions. ETF turnover for rebalancing purposes is generally handled in-kind to the extent possible; making them much more tax efficient. Even still, I might incur distributions or dividends, but I can hold ETFs in my RRSP (to defer tax) or TFSA (to avoid tax altogether). Traditional mutual funds buy and sell stocks and the transaction fees and portfolio turnover for this are passed on to me (rather you) Mr. Investor in the form of fees. Needless to say, I’m in more tax control with ETFs.

4. Strong allegiance to index investing.  Some ETFs are designed to track specific indexes such as the S&P/TSX LargeCap 60 . If I can’t own most of the stocks in the index (I’m working on it but I can’t afford them all!) I can own the index at a very low cost and be rewarded for index performance. Oh, and the other thing, index investing beats most actively managed mutual funds. That’s right, over any 10-year period of market study, the overwhelming majority of actively managed mutual funds by highly-compensated stock-picking gurus cannot keep up with their benchmarks. When the gurus do beat the index, know that the fund manager has often taken excessive risks in one segment of the economy (e.g., technology, energy, financials, other) to get returns. Over time, those big risks usually yield big consequences (read in: mutual fund losses). Since most ETFs are constructed to follow a particular index, only minor adjustments are needed with the ETF over time to mirror index performance. It doesn’t require the same overhead as actively managed mutual funds, therefore, low risk for good, predictable performance.

5. Great dividends and distributions. With most ETFs, dividends and distributions can be immediately reinvested. Each quarter (depending on the ETF you own…) I get paid for holding my ETFs. With each quarterly distribution, such as $0.30 for each XBB unit (that I used to own) I can take advantage of dollar-cost-averaging over time. Some equity mutual funds only pay out distributions at year end. Others, don’t pay out at all because distributions are at fund manager discretion. Does this sound good?

6. Simplicity. ETFs are simple and easy to understand.

7. Cost effective. I pay a transaction fee of less than $10 every time I buy ETFs for my RRSP and TFSA. (I don’t sell much!) The management fees for ETFs I buy are less than 0.50%. That’s almost four times lower than most actively managed equity mutual funds in Canada. That’s saving about 1.5% or $1,500 each year $100,000 is invested and remains invested. I like keeping my $1,500 each year instead of giving it to someone else.

I’m sure there are many more benefits to holding ETFs for investors out there, but the above are the big ones for me.