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July
2006
Like the famous utility tool, exchange traded funds are reliable, versatile and offer good value for money. Indirectly, they also share a little bit of history. The Swiss Army Knife’s beginning can be traced back to 1884 when Victorinox was founded. Although it would be over 100 years before the world’s first successful ETF was born, Canada’s own TIPS 35, a key ingredient of exchange traded funds, the index, also began in that year. Charles Henry Dow’s initial stock average, containing 11 stocks including 9 railroad issues, appeared in the Customer's Afternoon Letter, a daily financial news bulletin that was the precursor of The Wall Street Journal.
Twelve years later, the Dow Jones Industrial Average (DJIA) was first published. Today, of course, the DJIA is one of the most widely followed barometers of the US market and happens to have the fourth largest US ETF (DIA: AMEX) tracking it. A mission statement from Victorinox’s web site, “strive to produce high quality products that are functional, durable and offer the best value for money”, could equally apply to the ETF industry today.
An ETF is a hybrid security that trades just like a stock, but behaves like an index fund. For good reason, much has been written about utilizing the indexing feature of ETFs when constructing long-term oriented portfolios. By doing so, investors gain inexpensive access to an investment strategy that keeps fees (MERs as low as 0.09%) and trading costs low, tax efficiency high and backed by countless studies, outperforms the median active manager of the same asset class over most reasonable time periods. Furthermore, these “listed portfolios” are fully invested at all times, pure in content, and track their chosen bogey extremely well. These features make precise asset allocation possible, unarguably the most important decision for long-term investors. Savvy investors use ETFs to ‘tilt” their portfolios toward specific sectors as well as in tax loss harvesting strategies to boost after-tax returns. The breadth of choice, unavailable until recently and still expanding rapidly, brings most investment mandates within reach.
The 150 ETFs, listed on North American exchanges and available to Canadian investors, cover both fixed income and equity asset classes. Barclays Global Investors currently offers all bond ETFs, ishares tracking Government of Canada bonds and iShares offering exposure to both US sovereign and credit debt. Investors can
access total equity markets on a regional or country basis, own complete industry sectors or dissect many indexes by capitalization size and growth or value styles. In other words, complete, well-balanced and diversified portfolios, customized to suit any investor, can be constructed solely with ETFs.
Not as much has been written about the stock-like features of exchange traded funds. This is a shame because ETFs were built to trade, unlike mutual funds where penalties and restrictions on frequent trading are imposed. Similar to stocks, ETFs can be traded with market, limit or stop orders in margin, cash or registered accounts, with the big advantage of diversification built into that single transaction. Traders can go long or even short under any market condition and there are currently 77 ETFs with listed put and call options. The biggest misconception concerns liquidity or the ability to complete a transaction without significantly moving the market price against you. In fact, ETFs have two levels of liquidity. The first is the traditional liquidity in the marketplace and is maintained by market makers or specialists. For example, the i6o (XIU: TSX) has an “outside market” of 15,000 shares at a bid/ask spread of 10 cents. At a current price around $48 per share, that represents a $720,000 transaction. Usually, the i60 will be quoted inside the obligated market as market participants place their own orders. The second level of liquidity revolves around the fact that ETFs are open-ended trusts, like traditional mutual funds. However, unlike mutual funds, where all investors large and small exchange cash and units, only large institutional investors create new or redeem existing ETF units “in-kind” by delivering or receiving the underlying basket of securities in the same proportion to the index (this fungibility also ensures ETFs trade very close to fair value due to the arbitrage opportunity). Therefore, and this is key, it is the liquidity of the securities that comprise the index that determines the ultimate liquidity of the ETF, since more units can be assembled by simply delivering the appropriate basket. To illustrate, while the iShares DJ US Healthcare Sector Index Fund (IYH: AMEX) often trades less than $5 million per day, suggesting limited liquidity, the 176 stocks in the index averages $6.9 billion per day, displaying ample liquidity.
Not only do ETF investors and traders co-exist in harmony, having both types of market participants makes ETFs all the more efficient. Investors help boost the overall supply and traders increase the traditional liquidity allowing for better pricing for all market participants when they do wish to transact. Active investors can employ ETFs to quickly transition a portion or an entire portfolio into or out of the market. Trading and hedging strategies are countless, whether relying on fundamental, seasonal or technical analysis techniques. Of course, the diversified nature of the ETF will not be lost on anyone who has seen a strategy fail as a perennial blue chip disintegrates before their very eyes. Exchange trade funds are efficient, versatile and powerful investment tools that will enhance any investor’s portfolio.
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