Like a traditional managed fund, an exchange-traded fund (ETF) offers the opportunity to invest in a portfolio of securities, such as stocks or bonds.
As with a managed fund, each unit of an ETF represents an undivided interest in the underlying assets. ETFs and managed funds also offer professional management, so you don't have to keep track of every security the fund owns. However, ETFs are different in that they can be traded throughout the day on an exchange at a market-determined price, providing additional flexibility and efficiency.
Most ETFs use an indexing approach. They're built so that their value can be expected to move in line with the indexes they seek to track. For example, a 2% rise or fall in an index should result in approximately a 2% rise or fall for an ETF that tracks that index (before fees and expenses)
ETFs are traded throughout the day on exchanges at sharemarket-quoted prices, just like individual shares, bonds or property securities.
In contrast, managed fund units are bought and sold directly through the fund company at the fund's net asset value (NAV) at the end of each trading day.
Although they trade like individual securities, ETFs – like managed funds – are open-ended investments. That means new units can be created and existing units redeemed daily, based on investor demand. Closed-end funds and individual securities, on the other hand, generally issue a fixed number of units.
As ETFs are quoted investments, a 'share registry' manages the administration for investors by confirming settlement and providing distribution and tax information. Vanguard works with Computershare as their nominated share registry.
While any investor can purchase or redeem managed fund units directly with the fund manager or distributor, only authorised participants can interact directly with the ETF provider (for example, Vanguard) to create or redeem ETF units. Also, while managed fund investors generally exchange cash for managed fund units, the authorised participant can typically exchange the underlying securities or cash for new units of an ETF.
The ETF units that authorised participants create are then traded by investors on an exchange.
Important note: The information presented here addresses certain Canadian federal income tax considerations for Canada-resident individual investors. It is presented for general investor education, and does not constitute tax, legal, or financial advice. Please consult your tax and/or financial adviser for the tax results applicable to your specific situation.
ETFs offer several potential benefits, including low costs, liquidity, diversification and more.
It is important to keep in mind one of the main principles of investing: the higher the potential reward, the higher the risk of potential losses. The reverse is also generally true: the lower the risk, the lower the potential reward. An investment in ETFs could lose money over short or even long periods.
The price of the ETFs can fluctuate within a wide range, like fluctuations of the overall financial markets.
When considering an investment in ETFs, personal tolerance for fluctuating market values should be taken into account.
An investment in ETFs is subject to investment risk including possible delays in repayment and loss of income or principal invested. Neither Vanguard nor its associates guarantee the performance of the ETFs, the repayment of capital from the ETFs or any particular rate of return.
For more detailed information relating to the risks of a particular ETF, please refer to the relevant Product Disclosure Statement.
In Australia, ETFs are generally registered managed investment schemes. As such, they are subject to all the usual requirements for registered schemes under the Corporations Act 2001.
To be admitted to trading status, an ETF issuer must comply with the strict listing and trading rules of an exchange, such as the Australian Securities Exchange (ASX) Rules and Procedures (known as the AQUA rules, for ETFs). ASX created the AQUA market to specifically manage the admission of ETF securities, managed fund products and structured products (collectively referred to as 'AQUA products') on the ASX market.
The Australian Securities and Investments Commission (ASIC) has a close regulatory involvement with ETFs, and remains in dialogue with securities exchanges (such as the ASX), and with other foreign regulators, including the Securities Exchange Commission (SEC) in the United States and the Securities and Futures Commission (SFC) in Hong Kong. ASIC takes into account international literature and media on ETFs to inform their approach on ETF regulation.
The world's first ETF was created in Canada in 1990, transforming the investment landscape and offering the advantages of pooled investing and trading flexibility.
In their early days, ETFs were used primarily by institutional investors to execute sophisticated trading strategies. However, it wasn't long before individual investors and financial advisers embraced ETFs.
Since their introduction, ETFs have grown to become one of the most popular products in the global investment industry. Today, global ETF assets total more than AUD 4 trillion, invested in more than 6,100 ETFs.1 In the last five years, both the assets and the number of Australian ETFs have nearly tripled.2
ETFs and managed funds serve the same general purpose.
They provide exposure to particular markets or market segments. So it's not surprising that they share more similarities than differences.
1 Source: Morningstar, as at September 2019.
By pooling money from many investors, ETFs and managed funds have greater buying power, enabling them to buy many different securities in large quantities. This results in greater diversification than an investor can achieve buying individual shares and bonds. ETFs, like managed funds, can also provide diversified exposure to many segments of the market.
ETFs are subject to all the usual requirements for registered schemes under the Corporations Act 2001. Learn more
Compared with actively managed funds, indexed ETFs and index managed funds are extremely transparent. Investors generally know what the holdings are and in what proportion based upon the target index, particularly when a full replication strategy is used to track the index. Learn more
Orders to buy or sell ETF units are executed throughout the trading day at market-determined prices that change continually. On the other hand, an order to purchase or redeem managed fund units is executed at the end-of-day price, known as net asset value. Learn more about trading.
Both ETFs and managed funds charge a management cost which essentially covers ongoing operating costs. But because ETFs trade on exchanges, they also have unique costs not associated with managed funds. Learn more about costs.
ETFs can be used to implement a variety of short and long-term portfolio strategies.
Some of the uses for ETFs are strategic – for example, asset allocation – while others are tactical. Whether it makes sense to use ETFs in a particular strategy depends on a number of factors, including the dollar amount invested, holding period, trading costs, appetite for risk and more.
Here are some of the most common ways ETFs can be used in client portfolios.
Like managed funds, ETFs charge a management expense ratio (MER) to cover ongoing operating expenses.
But they also have some costs that aren't associated with managed funds.
Here are some of the most common ways ETFs can be used in client portfolios.
ETFs and managed funds charge fees to cover ongoing operating expenses, such as advisory services, administration and recordkeeping, among other things. These fees are expressed as a percentage of fund assets and are commonly known as the management expense ratio (MER).
ETFs tend to have lower MERs than managed funds. This is largely because most managed funds are actively managed and charge higher MERs than their index counterparts. As the vast majority of ETFs are index funds their MERs, on average, are lower than traditional managed funds.
Another reason ETFs can sometimes offer lower costs is that ETFs do not incur as many costs to maintain shareholder records, while managed funds must keep and maintain records of each individual shareholder.
Investors will incur customary brokerage fees and commissions when buying and selling ETF units on the securities exchange. The amount of this fee varies from broker to broker and can depend on the platform through which the transaction is made.
When buying or selling ETFs on an exchange, there is a difference between the price a dealer is willing to pay for an ETF share (the "bid") and the somewhat higher price the dealer will accept to sell that ETF share (the "ask"). As a result, an investor will typically buy ETFs for slightly over the intraday net asset value (NAV) price and sell for slightly less.
Bid-ask spreads are typically lower for ETFs that are heavily traded or that own securities that are highly liquid. Managed fund units do not incur bid-ask spread costs, as all trades are transacted at a fund's net asset value (NAV) at the end of the day.
ETFs are designed to trade on an exchange at a market price that approximates the market value of the ETF's underlying assets. Typically, the market price of an ETF is slightly higher (trading at a "premium" to) or lower (trading at a "discount" to) than the market value of the ETF's underlying assets.
Keep in mind that it is the change in premium or discount that affects an investor's returns, not the level of premiums and discounts – such as when an investor buys shares at a premium and later sells at a discount. There are no premiums or discounts associated with managed fund units, as they trade only at NAV, once a day.