An exchange-traded fund (ETF) is an investment vehicle that allows investors to buy an entire basket of securities through a single security. ETFs track and aim to replicate the returns of a particular stock market index, some of which are well known indices such as the S&P/TSX 60, while others are based on specific themes such as a specific geographic region or industry.

According to the Toronto Stock Exchange, it listed the world’s first ETF in 1990. The TSX continues to list ETFs and, as of June 30, 2008, there were 70 ETFs trading on the TSX with a market value of more than C$21 billion. In the first half of 2008, the TSX listed 22 new ETFs, which represent approximately 28% of all new TSX listings for that period.

ETFs are usually open-ended investment funds and are therefore in continuous distribution. They have a unique purchase and redemption feature that permits only large blocks of ETF units, usually called "creation units", to be purchased or redeemed in-kind instead of with cash. An institutional investor looking to purchase ETF units will generally need to deposit a portfolio of securities similar, in type and proportion to those held by the ETF, to assemble the creation unit(s) needed for the transaction. Generally, creation units consist of approximately 50,000 ETF units but can vary in size from 25,000 to 600,000 ETF units.

Investors can liquidate their ETF units in two ways. The first is to sell their ETF units on the open market, which is the common method for retail investors. The second option is to gather enough units of the ETF to form a creation unit in order to exchange it back for the underlying securities of the ETF.

Advantages of ETFs

There are several advantages to ETFs that make them attractive to investors. Management fees are significantly lower for ETFs compared to mutual funds because the underlying portfolio is generally not actively managed. They also provide an economical way of obtaining diversification and market exposure since an ETF unit represents an investment across an entire index. ETFs can be purchased and sold any time the market is open, unlike mutual fund transactions, which are executed only at the end of a trading day. In addition, ETFs allow the investor to sell short and exercise limit orders on the ETF similar to other securities listed on the TSX.

The Role of Arbitrage

ETFs are dependant on an arbitrage mechanism in order for their unit price to track net asset value. As a result, ETF units are rarely traded at any significant premium or discount to net asset value. The creation and redemption process allows institutional investors to capture any price discrepancy between an ETF’s market price and its underlying net asset value. The transparency of ETF portfolios facilitates this process since institutional investors know exactly which assets and how many are needed for a creation unit. The constant buying (or selling) of an ETF’s "basket of underlying securities" and selling (or buying) of the ETF units in the secondary market, then creating (or redeeming) ETF units to be delivered against the sale permit arbitrageurs to profit on any discrepancies in the pricing of such securities. The activities of arbitrageurs in turn tend to reduce the pricing discrepancies.

Risks and Other Considerations

ETF unitholders are subject to risks similar to those applicable to holders of other diversified portfolios, such as the basic market risk of a decline in the price of the securities in the ETF’s portfolio. The depth and liquidity of the secondary market is subject to fluctuations that can cause low trading volumes. International investments are subject to additional risks such as unfavourable currency changes, differences in accounting standards and possible economic or political instability experienced in a foreign country.

Institutional investors should also be concerned with the level of transparency of an ETF’s portfolio. Disclosure of the underlying assets is important for an effective arbitrage mechanism. A reduction in transparency can expose arbitrageurs to greater investment risk and reduce the efficacy of the arbitrage process. This could result in significant premiums or discounts in the price of the ETF units.

Actively Managed ETFs

Actively managed ETFs that do not track the return of a particular index have in recent years been introduced in the market. These special ETFs hold a mix of securities based on an ETF’s investment objectives and policies, without reference to the composition of an index. As they are actively managed, they are subject to higher fees than index ETFs but they still offer investors who prefer actively managed investments the benefits of ETFs at a lower cost than more traditional mutual funds.

Conclusion

ETFs are an expanding segment of publicly traded structured products in Canada and continue to increase in popularity among retail and institutional investors due to their growth potential, liquidity and the other advantages discussed above.