ETFs can bring diversification, reasonable fees and smooth out volatility when sharp highs and lows rattle stock pickers. Andres Rincon, Director, TD Securities, talks about how these alternative investments can be part of a balanced portfolio, and the mechanics, pricing and characteristics investors should look at before investing with ETFs.
Picking stocks traditionally works for investors. But with 2018 being called the year of volatility, there could be value in looking at alternative investments as part of a balanced approach.
Joining me to explain is Andres Rincon from TD Securities. Thanks for being here.
So I want to kick things off by asking you-- an ETF is a security, and it tracks a commodity, a bond, an index, a basket of assets. But what can you tell us about the mechanics around how that works?
So an ETF is basically like a mutual fund. But it trades on an exchange, as the name implies, obviously.
So the fund, in this case the main difference is that it has market makers. With a mutual fund, it does not really have a market maker. In the case of the ETF, we have market makers. And actually TD Securities is a market maker of ETFs.
So how it works, on a daily basis you would have the market maker making sure that there is a fair value for the ETF. And we do that by reducing any discrepancies in the ETF through arbitrage, by buying and selling the ETF on a daily basis to make sure that there's a fair value price on the market.
Now, there's the market making element, which you highlight. But there's also some element of a basket of assets. So why wouldn't someone just go out and buy those specific stocks, or the bonds that are included?
Well, diversification is the main reason. Obviously, if you just buy one stock or a couple bonds, then you're buying one single asset. You are buying one single risk. If you buy an ETF, in this case, you're buying a diversified basket of assets.
So in this case you would be buying, let's say, an ETF that tracks the financial world, or an ETF that tracks commodities, for example. So that's one good reason why you would actually do that.
On the flip side of that is that there are a lot of ETFs. All ETFs are very different. They have different structures. And you have to understand them correctly, because there are little small nuisances between one ETF to the other one.
What you just described sounds very similar to a mutual fund. So how would you describe the difference to an investor of an ETF versus a mutual fund?
Well, a mutual fund just only trades at 4:00 PM, basically. So it trades in that 4:00 PM. An exchange-traded fund, as the name implies, trades throughout the entire day. So you can come into the office at 9:30 in the morning, and you can trade your ETF. You can buy and sell it throughout the entire day. So that's one of the main differences that come with the ETF.
What that also leads to is liquidity. With your mutual fund, you don't necessarily get any visibility towards the liquidity of the fund, because it's only traded at the end of the day. In the case of the ETF, you can trade it throughout the entire day. And you can see how much it's trading in and out. And you're also getting natural buyers and sellers of that same product, which you wouldn't get with the mutual fund.
One of the big advantages also of ETFs is it's a bit more tax-efficient than other products, including if I'm talking about closed-end funds or a mutual fund. One of the reasons for it is the creation redemption process. When you have redemptions within a mutual fund, for example, that fund would have to sell the assets, and it will be a tax liability at that point. Or it would create a tax event.
When it comes to redemptions coming from an ETF, those assets from the ETF would just be transferred back into the investor as a basket. And that was not considered a tax event.
One of those differentiating factors I want to talk a little bit more about is the liquidity piece. You told me prior to the shoot, it's not just liquidity. It's something called implied liquidity. What does that mean?
So for sure. It's a very important point. That's actually the most common question I get.
What you normally see on the board, what you see on your machine when you're trading an ETF, is secondary liquidity. It's how often it trades on the exchange, basically.
And what that involves, it involves a lot of the market makers. And it involves also a lot of natural buyers and sellers. So one person selling to the other person. That matters a lot if you're looking at trading in and out an ETF very quickly.
But if you're looking at buying and holding an ETF, what we really care about is implied liquidity. Implied liquidity, what that means is the liquidity of the actual basket of assets within the fund.
So I'll give you a good example-- the S&P 500. Obviously the most traded index in the world. And there are many ETFs that track this specific index. You have ETFs that have been tracking it for a long time, and new ETFs that track it.
Some of the older ETFs have a lot of secondary liquidity, or liquidity that you see on the board, but don't have a lot of liquidity. Sorry. But the smaller ones wouldn't have that liquidity. But the actual liquidity of the assets themselves, which is the 500 stocks within the index, is the same.
So that's what matters. Because when it comes to a creation or a redemption of a unit of an ETF, what we care about is the impliedly liquidity of the ETF.
I want to shift gears a little bit now and talk about the market in Canada. What are some of the biggest trends you're seeing, and why is our market growing so much?
That's a very good question. Let me start by the trends. I think it's a very important part to highlight.
A sector that has been growing quite a bit more than other sectors in Canada is fixed income ETFs. Specifically within fixed income ETFs are preferred ETFs. Pretty much every other provider in Canada that we have has launched a preferred ETF. And they've grown their assets quite handsomely.
One of the reasons why I think this has been the case is because of active management, actually. In Canada you are allowed to have selective disclosure, or discretionary management of an ETF. In the US, you are not.
Because of that, a lot of the funds that are going from mutual funds are actually coming into ETFs, because we can do similar strategies within ETFs. In the US you just can't do that. It's all mostly passive.
So now that you have that gap, or that difference between the US and Canada, I think that a lot of those assets that are looking for active management have gone to ETFs in Canada.
Now, for investors thinking about adding ETFs to their portfolio, how do they find out what's available? And what are some of the characteristics that they should consider before making that purchase?
That is a very good question. And it's actually not a simple answer. It's hard actually to find a complete list of all ETFs. The best way for you really is to go to Web Brokers ETF Center. And then you will find far more resources about ETFs.
When it comes to what I look for in an ETF, it really depends if you're looking for passive or active management. If you're looking for active management, you want to know what's in the ETF. You want to know the way they're investing in it. And you want to know who the manager is.
If you're looking for passive, for example, then cost matters quite a bit for passive. So MERs and TDRs, which are Management Expense Ratio and Trading Expense Ratios, they matter quite a ton. And also, for passive, you want to know that it's tracking the index properly. So you want to make sure that the tracking error is really, really small.
So those are the main considerations that I'd take into account when looking at ETFs.
Andres, thanks very much for being here. You've given us lots around the market in Canada, how to compare ETFs versus mutual funds. Thanks for being here.