Post on 30-Sep-2020
transcript
Put ETFs to work for your clients
For financial advisor use only. Not for public distribution.
Contents
2 What are ETFs?
4 Potential benefits of ETFs
5 Comparing ETFs and mutual funds
6 How ETFs work
11 ETFs and indexing
For financial advisor use only. Not for public distribution.
Exchange-traded funds (ETFs) are attracting
ever-greater attention from investors. They
continue to grow globally, with assets of more
than $2.79 trillion. That trend translates to Canada,
where they are becoming a low-cost investment
vehicle of choice. Canadian-listed ETF assets
have more than quadrupled since 2008.1
But just how do you explain an ETF to your
clients? This guide will help you understand how
ETFs work and the potential ways you can use
them in your clients’ portfolios.
1 Source: ETFGI, December 31, 2014.
1For financial advisor use only. Not for public distribution.
What are ETFs?ETFs are mutual funds that are listed, bought
and sold on a regulated stock exchange, typically
through a stockbroker or brokerage platform. ETFs
offer the opportunity to invest in a portfolio of
securities that provide the same diversification
benefits of mutual funds with the added benefits
of liquidity and trading flexibility of individual stocks.
And ETFs, on average, cost less than mutual funds.
While most mutual funds in Canada are actively
managed funds, which try to outperform the
market, ETFs in Canada are primarily passively
managed index investments. They seek to track
the performance of a broad market or a specific
portion of it. Most index-based ETFs invest in all
or a representative sample of the securities of the
indexes they seek to track.
Tracking an index
ETFs that use an indexing approach are built so
their value can be expected to move in line with the
index they seek to track. For example, a 2% rise or
fall in the index should result in approximately a
2% rise or fall for an ETF that tracks that index.2
2
Index fund
Diversi�edLow cost
Low turnover
Individual stock
Continuously pricedLiquid
ETF
2 An ETF with a low tracking error will not generally outperform the applicable index, but rather will produce a return similar to the index minus fees and expenses.
For financial advisor use only. Not for public distribution.
How ETFs are traded
Investors and their financial advisors must trade
ETFs through a brokerage firm. Units can be bought
and sold at the current market price whenever the
stock exchange is open. Unit prices typically reflect
the approximate value of the ETF’s underlying
shares at any given point in the day.
Mutual funds, conversely, can be bought and sold
directly through the fund company. Regardless
of when you place an order, the purchase or sale
takes place only once, at the end of the day, at
the same price for all investors (See Figure 1).
MarketplaceInvestment
advisorInvestment
advisorETF
buyerETF
seller
Figure 1
3For financial advisor use only. Not for public distribution.
Potential benefits of ETFsETFs offer several potential benefits. Taken as a
whole, these benefits tell a compelling story about
why ETFs may belong in a portfolio. Any one of
them may resonate with a given client.
Low costs
Annual management expense ratios of index-based
ETFs can be less than those of many conventional
index funds, and significantly less than those of
actively managed funds. However, you need to
consider the “all-in” cost of investing in ETFs to
determine whether they are right for your clients.
This is because ETFs have costs associated with
trading in the stock market, such as brokerage
commissions and bid-offer spreads.
Diversification
Index funds and index ETFs invest in all or a
representative sample of the securities in an index
and provide a diversified investment. This offers
access to a wider range of investments than an
individual investor may otherwise have. Keep in
mind that diversification does not ensure a profit or
protect against a loss in a declining market, and
that it is not possible to invest directly in an index.
While Vanguard ETFs are designed to be as
diversified as the original indexes they seek to track
and can provide greater diversification than an
individual investor may achieve independently, any
given ETF may not be a diversified investment.
Trading flexibility
ETFs are traded on a stock exchange, so they
can be bought and sold through an advisor or a
brokerage account any time the exchange is open.
Investors can use stock-trading techniques such as
stop and limit orders and short-selling. And ETFs
can be bought on margin.
Of course, like stocks, ETFs are subject to the
traditional risks and potential rewards of the
markets. The value of ETF units will rise and
fall as markets fluctuate, so an ETF can gain
or lose value over short or long periods.
Liquidity
The ability of dealers to create and redeem ETF
securities on a regular basis ensures an underlying
depth of liquidity. Unlike mutual funds, ETFs can be
traded at market prices throughout the trading day
at a price quoted on a regulated stock exchange.
Transparency
With straightforward physical ETFs, the issuer
provides daily information to the market, including
the ETF basket, or a close representation of
the ETF portfolio, making ETFs a transparent
investment option. The difference between physical
and more specialist synthetic ETFs is covered on
pages 6 and 7.
Potential for tax efficiency
Taxes have the potential to take a bite out of
investment returns, so tax-efficient funds may have
a place in your clients’ portfolios. The low turnover
of an indexing approach can minimize capital gains
distributions, which can, in turn, improve long-term
after-tax performance and tax efficiency.3
Low manager risk
ETFs based on indexes and index funds virtually
eliminate the exposure to manager risk. That’s
because they seek to track, not outperform,
a market index. Active fund performance is
less predictable.
4
3 Although index funds typically do make fewer trades, changes to the underlying index will require the index fund to buy or sell shares in accordance with changes to the index it seeks to track.
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Investment fund managers either seek to track an index or to outperform an index using an active
management strategy. The detailed comparison of investment-type characteristics below can
help put ETFs in context.
Comparing ETFs and mutual funds
5
4 Source: Investor Economics. Straight average management expense ratios (MERs) as of December 31, 2014, using data compiled from management reports of fund performance. The average MER for index mutual funds includes only A-, ADV-, T-, F-, HNW- and D- series index mutual funds and excludes ETFs, funds with performance fees, money market funds, funds with management fees charged at account level. The average MER for actively managed mutual funds includes A-, ADV-, T-, F-, HNW- and D- series mutual funds and excludes ETFs, funds with performance fees, money market funds, funds with management fees charged at account level, hedge funds, index funds and LSVCC funds.
ETFs Index mutual funds Actively managed mutual funds
Access Units bought and sold through a stockbroker or platform offering brokerage services
Units bought and sold directly through the fund company or through an advisor
Units bought and sold directly through the fund company or through an advisor
Pricing Unit prices set by the market throughout the trading day
Net asset values determined once per trading day, after financial markets close
Net asset values determined once per trading day, after financial markets close
Management expense ratios4 0.79% 1.94% 1.91%
Transaction costs Brokerage commissions and bid-ask spreads on each direct purchase and sale
None for funds that don’t have a sales charge when purchased or redeemed directly with the fund. (Some funds do have sales charges)
None for funds that don’t have a sales charge when purchased or redeemed directly with the fund. (Some funds do have sales charges)
Dividend reinvestment
Availability depends on the fund sponsor or your broker, who may charge for the service
Generally available at no charge Generally available at no charge
Client services Provided by the broker Provided by the fund sponsor or a broker
Provided by the fund sponsor or a broker
For financial advisor use only. Not for public distribution.
ETFsponsor
Individualinvestors
Trade on Toronto Stock
Exchange
Hold units
Dealer (Certain institutional investors, such as brokerage houses)
Basket of securities
One creation unit(e.g. 50,000 units of ETF)
How ETFs workYour clients may have several questions about ETFs,
such as how they’re traded and the costs involved,
and even how an ETF comes into being. This
section covers these topics and more.
Creation and redemption
ETFs generally don’t experience cash flows into
or out of the fund. That’s because only certain
institutional investors (brokerage houses, for
example) are authorized to purchase or redeem
units directly, and they do so almost exclusively
using securities.
When these institutional investors purchase units
of an ETF, they give the ETF a specific quantity of
securities. The securities in this “basket” are part of
the index the ETF seeks to track. Similarly, when
these institutions redeem their ETF units, the ETF
generally provides them with securities, not cash
(See Figure 2).
During these “in-kind” transactions, the ETF incurs
minimal transaction costs and does not realize
capital gains.
Some baskets, however, don’t physically contain the
securities that an index seeks to track. Innovation in
the industry has led to the introduction of swap-
based ETFs, where the basket may be unrelated to
the index, and one or more counterparties agree to
pay the index return to the ETF.
Also known as synthetic ETFs, swap-based ETFs
may make sense in certain instances, such as in
gaining exposure to markets that are difficult to
access. But it’s essential to understand how the
ETF is structured and its practices around collateral,
transparency and liquidity.
6
ETF redemption works in reverse, with the dealer providing ETF units to the ETF sponsor in return for underlying securities.
Figure 2
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Secondary-market trading
Perhaps the most noticeable way ETFs differ from
mutual funds is how they are bought and sold.
Institutional investors can sell their ETF units to
individual investors on the secondary market.
These individual investors may then sell their
ETFs to other investors for cash.
Individual investors and their financial advisors
must trade ETFs through a brokerage firm. ETFs
can be bought and sold at the current market price
whenever the stock exchange is open. Unit prices
typically reflect the approximate value of the ETF’s
underlying securities at any given point in the day.
Most of these market trades, however, have no
effect on the ETF itself; no cash flows into or out of
the ETF that would require it to purchase or sell
portfolio securities, pay brokerage commissions, or
realize capital gains. As a result, the ETF is largely
able to hold down its operating costs and limit the
distribution of capital gains to unitholders
(See Figure 3).
Of course, individual investors are subject to any
brokerage commissions and capital gains triggered
by trades on their behalf. Keep in mind that the
market price of ETFs may be more or less than
the value of the underlying securities.
7
Figure 3
Stockexchange
Places “buy” order for ETF unitson behalf of Investor A.
Initiates transaction with stock exchange.
Initiates transaction with stock exchange.
Completes transaction with brokers. Unit
ownership changes from Investor B to Investor A.
Places “sell” order for ETF unitson behalf of Investor B.
BrokerB
AdvisorB
Works with advisor to create an investment mix that’s right
for him or her.
InvestorB
BrokerA
AdvisorA
Works with advisor to create an investment mix that’s right
for him or her.
InvestorA
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Trading options
Because ETFs trade like stocks any time during
regular exchange hours, you can execute specific
strategies to help your clients achieve their
investment objectives.
Here are some ways that ETFs can offer greater
flexibility than mutual funds:
A market order is an order to buy or sell a security
immediately, at the market price. Execution, not
price, is the priority, so with a market order, the
price you receive can be unpredictable. You may
want to consider using stop and limit orders to help
protect your clients from trading a security at a
lower or higher price than they want to.
A limit order is an order to buy or sell a security at
a specified price or better. Limit orders may not be
executed immediately. They may be executed only
partially, or not at all, depending on the availability
of buyers or sellers at the price you have specified.
A stop order is an order that triggers a market
order to buy or sell a stock once it reaches a certain
unit price, known as the stop price. Be aware that
stop orders may be triggered by temporary market
movements or may be executed at prices higher or
lower than the stop price because of market orders
placed ahead of them.
Buying on margin allows your client to borrow a
percentage of an ETF’s value from the broker in
order to purchase the ETF. Be aware that if the
value of the ETF drops substantially, your client
may have to deposit more cash in the account or
sell some of the ETF.
Short-selling is an investment technique that
involves essentially borrowing a security and then
selling it with the intent to buy it back at a lower
price. Short-sellers hope to make money when the
market goes down. If a security you have sold short
for a client rises in value, however, your client can
lose money—and there’s no limit to how much he
or she can lose.
In some cases, you can short-sell ETF units to
hedge the risk of your client’s other investments.
You can also shift assets out of and back into an
ETF on a short-term basis to realize any capital
losses and better manage your client’s tax liability.
Excess return and tracking error
Excess return and tracking error can help you
evaluate ETFs. But to use the measures effectively,
you need to understand what they represent and
how much weight to give them in your evaluations.
Excess return shows how a product’s perfor mance
compares with that of its benchmark over a given
period. Tracking error indicates the consistency of
a product’s excess return in the same period.
8 For financial advisor use only. Not for public distribution.
As with any investment, operating costs vary
among ETFs. Generally, ETFs cost less to operate
than both index and actively managed mutual funds.
Because ETF investors place transactions through
brokerage firms, the ETFs do not incur the
administrative costs that mutual funds incur for
such things as correspondence, customer service
and account recordkeeping. That can allow ETFs
to keep management expense ratios low, which
leaves more money to work for investors over
the long term.
Keep in mind, however, that ETFs do incur
transaction costs. Your clients likely will pay
brokerage commissions whenever you buy
or sell ETF units for their portfolios.
ETF market prices also reflect bid-ask spreads.
This is the difference between what an investor
sells a security for and the somewhat higher price
at which the investor buys the same security.
Like other investment costs, these expenses
are borne by the individual investor and can affect
investment returns.
Costs
When selecting products for your clients’ portfolios,
it’s important to keep excess return and tracking
error in context. If total return is your primary
criterion, then excess return will likely be more
important than tracking error in your evaluations.
If performance consistency is more important to
you, then tracking error may be more relevant.
Liquidity and average daily volume
Investors who place large orders may pause when
they see an ETF with average daily volume that
they perceive as small. They may wonder whether
liquidity is sufficient to receive the best price at the
trade size.
More important than the liquidity of an ETF,
however, is the liquidity of its underlying securities.
Why? It’s a function of the creation and redemption
process. When demand exists for ETF units, for
example, a dealer can provide the ETF sponsor
with a basket of underlying securities to create
the units. The liquidity of the underlying securities
is paramount.
ETFs trade on an exchange like stocks. Whereas a
large trade in a single stock can affect the trading
price, a large trade in an ETF can be achieved,
when necessary, through the creation or
redemption of ETF units. The creation and
redemption mechanism relieves the pricing
pressure of large trades.
So average daily volume for an ETF is not the only
gauge of liquidity. Also important to how any ETF
may trade is the average daily volume of its
underlying securities.
9For financial advisor use only. Not for public distribution.
10
When market volatility climbs, trading securities can
become challenging. To help your clients obtain best
execution when buying or selling ETFs, you may want
to consider the following:
Be aware at the open and close. At the open, not all
underlying securities in an ETF may have begun trading.
In such situations, the market maker can’t price the ETF
with certainty, potentially causing wider bid-ask spreads.
At the close, fewer firms may be making markets in the
ETF and fewer securities may be listed for purchase and
sale than throughout the trading day.
Consider using a block desk. When you place large
orders, a block desk can break your trade into smaller
increments over time to manage the effects of a large
trade. Or it can create or redeem units directly with the
ETF sponsor so as not to affect prices on the secondary
market. Your block desk can also review pricing depth
before placing a trade.
Keep up with the news. ETFs can briefly trade at a
premium or a discount to the net asset value of their
underlying holdings. Such swings can result from the
release of economic indicators or statements from
central banks, as well as earnings and other news
from companies that are large constituents of an
ETF and its benchmark.
A few cautionary words
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Most ETFs in Canada, including those managed by
Vanguard Investments Canada Inc., are indexed
investments. Most Canadian mutual funds,
meanwhile, are actively managed. Managers
of indexed investments seek to track—not
outperform—a market index. Managers of active
funds, on the other hand, seek to outperform
the market.
Why would your clients be satisfied with earning
what the market earns, minus costs? Because
while outperformance is possible over short
periods, Vanguard research shows that long-term
outperformance of any one active manager is rare.5
Investing is a zero-sum game. All investors’
holdings represent the market. For each investor
dollar that outperforms, another must under-
perform. Factor in the costs of running a fund and
your odds of outperforming grow longer. The costs
of indexed investments generally are lower than
those of actively managed investments. In Canada,
they’re much lower.
Vanguard ETFs™ enjoy the low portfolio turnover
that typically comes with indexing. Because
indexed investments seek to track a market
index, they don’t need to constantly buy and
sell securities, so they can limit the distribution
of capital gains to investors.
Vanguard and indexing
When you invest with Vanguard, you have almost
40 years of index investing experience behind you.
The Vanguard Group, Inc. launched the first equity
index mutual fund for individual investors in 1976 in
the United States. Funds based on bond and
international indices followed in 1986 and 1990.
We’ve since applied our index management
expertise to exchange-traded funds.
As we’ve developed proprietary software and
sophisticated techniques for portfolio construction,
risk management and trading, we’ve also grown
in size, scale and experience. Investors benefit
through tight, low-cost benchmark tracking.
Of course, an index investment is only as good as
the benchmark it seeks to track. We select only
market-capitalization benchmarks, which objectively
reflect broad markets or market segments and thus
minimize investment costs. Many index providers
use benchmark construction best practices that
Vanguard has promoted for years – an industry
endorsement of our leadership.
You can feel confident that your clients’ returns will
be close to the market’s returns, minus expenses,
and that your clients will know where their money
is invested.
11
5 The case for index-fund investing for Canadian investors, Christopher B. Philips et al., The Vanguard Group, July 2014.
ETFs and indexing
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12
Alternative indexing?
Some index constructors employ alternatives
to market-capitalization weighting. They screen
securities based on certain financial measures
in an attempt for greater performance.
These financial measures typically result in
exposures that tilt toward investments in value
stocks and small- and smaller-cap stocks. In bonds,
a popular alternative strategy has been to focus on
countries and companies and reweight default and
interest rate risks relative to a market-cap-weighted
index. These alternative index strategies can carry
higher management expenses than market-cap-
weighted indexing investments. If you’re truly
looking to capture the market’s returns, you may
want to consider low-cost index funds that
encompass the entire market.
Whatever the configuration, we view any portfolio
that employs a non-capitalization weighting scheme
as an active portfolio. When evaluating an
alternative-investing framework, investors should
consider their tolerance for active risk.
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As you consider ETFs for your clients’
portfolios, you can count on Vanguard’s
indexing expertise and our record of
putting investors first.
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© 2016 Vanguard Investments Canada Inc. All rights reserved.
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Date of publication: October 2015.
In this material, references to “Vanguard” are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its affiliates, including Vanguard Investments Canada Inc.
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