What benefits can ETFs offer?
The benefits offered by one investment type over another investment type are often in the eye of the investor. Where one investor perceives a benefit, another investor may not. Benefits may also be perceived differently depending upon the investments that are compared. In most instances when a discussion occurs around the benefits of ETFs it is based upon a comparison with mutual funds.
In their simplest of forms ETFs can offer benefits to any portfolio by helping to maintain a lower investment cost, providing a portfolio with additional diversification and providing a well-structured, passive method of gaining exposure to asset categories that would otherwise be difficult to attain.
A few of the benefits ETFs may provide are listed below:
- Transparency: Unlike mutual funds, ETFs are required to disclose daily the investments held by the fund, so an investor always knows exactly what they are investing in and how much of the their investment is maintained in each constituent. The better an investor’s understanding of their investments, the better control they will have on their eventual investing success or failure. Because the EFT is created in the exact image of an established index, information is readily available. Because each ETF has a stock exchange symbol, or ticker symbol, an investor can watch the ETF activity and changes throughout the trading day.
- Low investment costs: Because the management expense ratios (MER) for ETFs are lower than those of mutual funds, an investor’s costs are minimized. For example, the MER for a well-known ETF that tracks the S&P/TSX 60 Index has an MER of 0.17%. This compares to the estimated average MER for a similar mutual fund at 2.36%, per year. Over time, this lower MER is a tremendous benefit. In addition to the annual MER, ETFs also have transaction costs associated with each purchase and sale.
- Diversification: ETFs offer investors the benefit of investment diversification similar to that offered by mutual funds.
- Tax efficiency: In general, an index investment would tend to have a low portfolio turnover rate and, as a result, is expected to realize fewer capital gains. Unlike traditional mutual funds where unitholder redemptions can contribute to capital gains distributions, the ETF’s Creation and Redemption structure minimizes the income tax consequences of other unitholder activity. In addition, ETFs have a unique tax-efficient in-kind redemption process available to them through designated brokers at the fund level, which reduces the amount of capital gains that must be distributed to investors.
- The creation and redemption process: The ETF creation and redemption process is responsible for many of the benefits ETFs provide over traditional mutual funds. Investors in ETFs deal directly with a stock exchange rather than a mutual fund company, which helps ETFs be more tax efficient. While ETF units trade on an organized exchange (as do common shares), the process by which their units are created is significantly different. For common shares, unless a company decides to issue more shares, the supply of shares trading in the stock market is finite. This is not the case for EFT units.
- When the demand for ETF units increases, the Designated Broker (DB) or Market-Makers have the ability to create units on demand.
- For ETFs, the Designated Brokers (typically specialists on the exchange or institutional brokers/dealers) can create or redeem units directly with the fund through an in-kind transfer mechanism. Designated Brokers create ETF units by delivering a basket of securities to the fund equal to the current holdings of the ETF. In return, the Designated Brokers receive a large block of ETF units (typically 100,000 units) that investors can then buy and sell in the secondary market.
- The process also works in reverse where if an investor wishes to sell a large block of units of an ETF and there seems to be limited liquidity in the secondary market, the Designated Broker is prepared to take and redeem them.