How is an ETF designed?

The simplest ETFs attempt to replicate the performance of a well-established stock or bond indices.  These ETFs are classified as Passive investments because the individual investments held in the ETF basket are decided by the construction methodology (i.e. set of rules) established by the index provider. Changes to the ETF are not at the discretion of a portfolio manager or committee. A change in an ETF holding only occurs when the index provider initiates a change in the underlying index based upon its well-established guidelines for inclusion or exclusion in the index.

An index is a collection of individual securities intended to represent a certain market or market segment.

Example: The S&P/TSX 60 Index holds the individual common shares of the 60 largest, as measured by market capitalization (the share price multiplied by the number of shares issued and outstanding), and most liquid companies listed on the Toronto Stock Exchange. The 60 companies are selected for inclusion in the index by the Standard & Poor’s company using its industrial classifications and guidelines for evaluating each company’s market capitalization, liquidity, and fundamentals.

An ETF that is designed to replicate this index, therefore, will invest in the exact same 60 companies, in the same proportions as the index, by holding the common shares for those companies. The ETF will continue to hold those 60 constituents until the Standard and Poor’s adds or deletes a company based upon its established capitalization, liquidity and fundamental criteria. There is no portfolio manager or committee actively trying to outperform the S&P/TSX 60 Index. The ETF simply wants to earn the same returns or losses as the underlying S&P/TSX 60 Index itself.

With the dramatic growth in ETF offerings we have witnessed dramatic new ETF structures and a growing phenomena where brand new indices are being created so that ETF providers can then build and offer an ETF for that newly created index. As a result of this expansion, investing in ETFs has become more burdensome for investors.

Remember:  It is important that investors not only understand how the individual ETF is structured and operates, it is just as important for investors to understand how the underlying index is constructed and managed.

Investors can no longer assume that an underlying index is built and managed as it was 3 years ago, 5 years ago, or 10 years ago.  For example, the S&P/TSX Composite Index (the index all investors watch) is not the same index that we watched prior to 2002 when the Standard & Poor’s contracted to build and manage the index. It makes one wonder, therefore, if the Composite’s historical performance, prior to 2002, should be used when analyzing the Canadian stock market’s performance.

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