Lifting the veil on ETFs – Part 1 of 4

Recently, one of the big 5 banks did a customer survey on ETFs and one of the questions was: “What do the letters ETF mean?” The responses shared were interesting to say the least! Most thought they stood for Emergency Task Force! Another group though it was an abbreviation for Energy Transfer Fund (like a carbon offset trading scheme I presume), some said it was an Environmental Trust and still others suggested Electronic Transfer of Funds. Apparently, less than 5% correctly identified the letters as meaning Exchange Traded Funds! Interesting to say the least since ETFs are attracting lots of attention these days, for various reasons – some accurate and others not.

They’re still quite new and would-be investors are bound to have lots of questions. In this article, I am only going to touch on the generalities of ETFs and some of the more common versions. Future issues of Money Magazine and this blog will delve more deeply into each area discussed here.

An (ETF) is an investment fund traded on a stock exchange much like a stock. It holds assets such as stocks, commodities or bonds and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index. ETFs may be attractive as investments because of their apparent lower costs, potential tax efficiency and stock-like features.

What is an index?
You probably know terms such as the S&P/TSX Total Return Index (the most quoted Canadian index) or the S&P 500 Index in the US on the news. Those are indexes. An index is a selection of stocks or bonds that represents a given market. Each index has rules about how many securities are included and how they are weighted. Indexes are mainly used to measure changes in the market they represent. Remember, an Industrial Average (such as the Dow Jones Industrial Average {DJIA} is NOT an index, but that is a subject for another review!).

An ETF combines the valuation features of a mutual fund which is bought or sold at the end of each trading day for its net asset value, with the tradability features of a stock or bond which trades throughout the trading day at varying.

Structure
ETFs offer investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds except that shares in an ETF are bought and sold throughout the day through a broker-dealer. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value, or NAV. Instead, brokers purchase and redeem ETF shares directly from the ETF.

Index ETFs
Most ETFs are index funds that attempt to replicate the performance of a specific index. They may be based on stocks, bonds, commodities or currencies. An index fund seeks to track the performance of an index by holding in its portfolio either the contents or a representative sample of the securities in the index. Some index ETFs, known as leveraged ETFs or inverse ETFs, use investments in derivatives to seek a return that corresponds to a multiple of, or the inverse (opposite) of, the performance of the index.

Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called “replication”. Other index ETFs use “representative sampling”, investing perhaps 80% to 90% of their assets in the securities of an underlying index and investing the remaining 10% to 20% of their assets in other holdings such as futures, option and swap contracts and securities not in the underlying index. There are various ways the ETF can be weighted, such as equal weighting or revenue weighting.

Ian Whiting

Ian R. Whiting CD, CFP, CLU, CH.F.C., FLMI (FS), ACS, AIAA, AALU With more than 40-years of experience in the industry, Ian has qualified 3 times for MDRT, completed LUATC in 1979, the LUAC Financial Planning Skills Course and attended numerous Schools in Agency Management and Sales Management through LIMRA. He obtained his CLU in 1987 while also completed his IFIC qualification and completed his Fellowship in the Life Management Institute with a specialty in Financial Services in 1988. In 1989, he completed qualifications for his Chartered Financial Consultant designation. In 1992, he qualified as an Associate of the Academy of Life Underwriters (Head Office underwriter qualification) and in 1993 he completed his Associate, Customer Service designation program through LOMA. In 1997, he qualified as a CFP and also completed his courses and exams to obtain the Associate, Insurance Agency Administration designation. In 1999, he completed the study and examinations to qualify as a Trading Officer, Partner and Director for Mutual Funds with the BC Securities Commission. As a result, he is also qualified as both a Branch Compliance Manager and Head Office/Provincial Compliance Officer. He served for nearly 18 years with the Canadian Forces (Air) Reserve (reaching the rank of Captain) primarily working with Air Cadets and was award the Canadian Forces Decoration (CD) in 1982. Long known as a maverick and forward thinker in the financial services world, Ian enjoys the challenge of learning new material and planning for the future evolution of his chosen profession.