19.1 Introduction

Understanding Exchange-Traded Funds (ETFs)

An Exchange-Traded Fund (ETF) is an investment vehicle that amalgamates characteristics of both mutual funds and individual stocks. They are typically structured as open-end mutual fund trusts and are regulated similar to mutual funds under the National Instrument 81-102. Certain ETFs are also subject to National Instrument 81-104, which regulates funds that involve commodities and derivatives either individually or in combination.

• National Instrument 81-102: Governs mutual funds in Canada including ETFs.
• National Instrument 81-104: Regulates commodity and derivatives funds.

Management Styles of ETFs

Passive Management

Passive management in ETFs aims to create a portfolio that tracks specific market indices such as the S&P/TSX 60 Index or the S&P 500 Index. The majority of ETFs are passively managed, reflecting the performance of their benchmark indices. Some Common Market Indices Tracked by Passive ETFs:

• S&P/TSX 60 Index: Represents 60 of the largest companies listed on the Toronto Stock Exchange.
• S&P 500 Index: Comprises 500 of the largest U.S. companies.

Active Management

Although most ETFs are passively managed, there is a growing number of actively managed ETFs. These funds aim to outperform their benchmark indices through various investment strategies practiced by professional portfolio managers.

Trading ETFs: An Overview

Unlike traditional open-end mutual funds, units of an ETF are listed and traded on a stock exchange or an alternative trading system much like individual stocks. This can be revolutionary as it allows ETFs to be bought on margin and sold short. Additionally, some ETFs have options trading available, which adds a layer of flexibility and strategy for investors.

Key Advantages of Trading ETFs

• Liquidity: ETFs can be traded throughout the trading day at market price, unlike mutual funds which are traded at the end of the day’s Net Asset Value (NAV).
• Flexibility: ETFs offer the option to trade with margin and sell short.
• Accessibility: Purchasable through regular brokerage accounts without needing specialized fund accounts.
• Diverse Strategy Implementation: Options trading allows for varied risk management and leverage strategies.

Frequently Asked Questions (FAQs)

What are the major differences between ETFs and mutual funds?

ETFs trade on stock exchanges like individual stocks, while mutual funds are usually bought and sold at the end of the trading day at the closing NAV. ETFs generally offer higher liquidity and real-time trading capabilities.

Can ETFs be actively managed?

Yes, while majority of ETFs are passively managed, tracking an index, a growing number of them are actively managed involving active buying and selling of assets by the fund manager.

What is the regulatory framework governing ETFs in Canada?

In Canada, ETFs are regulated under the National Instrument 81-102 which governs mutual funds. ETFs involving commodities and derivatives also fall under National Instrument 81-104.

Key Takeaways

• ETFs combine features of mutual funds and individual stocks.
• They can be both passively and actively managed, although passive management tracking market indices is more common.
• ETFs are traded on stock exchanges, allowing real-time trading, margin buying, and short selling.
• ETFs offer benefits of liquidity, flexibility, and diverse strategy options.

Glossary of Terms

• ETFs (Exchange-Traded Funds): Investment funds traded on stock exchanges, similar to stocks, but offering diversified portfolios akin to mutual funds.
• Passive Management: Investment strategy aiming to replicate the performance of a specific index.
• Active Management: Strategy where a portfolio manager actively makes investment decisions to outperform the market index.
• National Instrument 81-102: Regulations overseeing mutual funds in Canada, including ETFs.
• National Instrument 81-104: Regulations governing funds involving commodities and derivatives.
• Liquidity: Ease with which an asset can be bought or sold in the market without affecting its price.
• NAV (Net Asset Value): The total value of a fund’s assets minus its liabilities, usually calculated at the end of each trading day.
• Margin Buying: Purchasing securities by borrowing a portion of the purchase cost from the broker.
• Short Selling: Strategy where a trader sells a security they don’t own, anticipating a decline in value.