put etfs to work for your clients - vanguard canada · 2016. 7. 25. · how etfs work your clients...

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


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.


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


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.


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


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


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


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.


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


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


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.


As you consider ETFs for your clients’

portfolios, you can count on Vanguard’s

indexing expertise and our record of

putting investors first.


© 2016 Vanguard Investments Canada Inc. All rights reserved.

EBBCA 042016

Connect with Vanguard™

vanguardcanada.ca888-293-6728

Vanguard Investments Canada Inc.

Bay Adelaide Centre22 Adelaide Street WestSuite #2500Toronto, ON M5H 4E3

Commissions, management fees, and expenses all may be associated with investments in a Vanguard ETF®. Investment objectives, risks, fees, expenses, and other important information are contained in the prospectus; please read it before investing. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. Vanguard ETFs® are managed by Vanguard Investments Canada Inc., an indirect wholly-owned subsidiary of The Vanguard Group, Inc.

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.

This material is for informational purposes only. This material is not intended to be relied upon as research, investment, or tax advice and is not an implied or express recommendation, offer or solicitation to buy or sell any security or to adopt any particular investment or portfolio strategy. Any views and opinions expressed do not take into account the particular investment objectives, needs, restrictions and circumstances of a specific investor and, thus, should not be used as the basis of any specific investment recommendation.

Information, figures and charts are summarized for illustrative purposes only and are subject to change without notice.

While this information has been compiled from proprietary and non-proprietary sources believed to be reliable, no representation or warranty, express or implied, is made by The Vanguard Group, Inc., its subsidiaries or affiliates, or any other person (collectively, “The Vanguard Group”) as to its accuracy, completeness, timeliness or reliability. The Vanguard Group takes no responsibility for any errors and omissions contained herein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this material.

This material does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.


put etfs to work for your clients - vanguard canada · 2016. 7. 25. · how etfs work your clients...

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