An exchange-traded fund (ETF) is a type of investment fund that is bought and sold on stock exchanges, just like a stock. ETFs hold a basket of assets such as stocks, bonds, commodities, or currencies, providing investors with instant diversification and market liquidity. In Canada, ETFs have transformed investing by offering millions of Canadians a transparent, flexible, and cost-effective way to save for retirement and build wealth. They trade on exchanges like the Toronto Stock Exchange and can be held in both registered and non-registered investment accounts.
What Is an Exchange-Traded Fund?
An exchange-traded fund is a pooled investment vehicle that owns a collection of financial assets. These assets can include stocks, bonds, currencies, commodities like gold bars, debt instruments, futures contracts, and even cryptocurrencies. By holding these diverse assets, an ETF provides investors with exposure to a broad market segment or strategy through a single security. Unlike mutual funds, which are priced once per day after markets close, ETFs are priced continuously throughout the trading day. Their shares are quoted and traded on stock exchanges, allowing investors to buy and sell them at any time the market is open, using the same types of orders available for stocks, such as limit orders.
The legal structure of an ETF can vary by country, taking the form of a corporation, trust, open-end management investment company, or unit investment trust. In Canada, ETFs are regulated by provincial securities commissions and are subject to securities laws. Shareholders indirectly own the underlying assets of the fund and are entitled to a share of the profits, such as interest or dividends. They also receive annual reports and would be entitled to any residual value if the fund undergoes liquidation. Commodity ETFs, such as those holding physical gold, are often structured as grantor trusts, giving shareholders a direct interest in a fixed portfolio of the commodity.
Most ETFs are designed to be transparent about their holdings. Actively managed ETF issuers in the United States are required to publish their portfolio composition daily, while index fund ETFs may do so monthly. The primary document outlining an ETF's investment objectives, strategies, and fees is called a prospectus. Investors pay annual fees to the ETF issuer, known as the expense ratio or Management Expense Ratio (MER), which covers management and operating costs. Trading ETFs may also involve stockbroker commissions and applicable financial transaction taxes.
How ETFs Work: Creation, Redemption, and Trading
ETF shares are created and redeemed through a mechanism involving large financial institutions known as authorized participants. These entities, typically broker-dealers, interact directly with the ETF issuer. They create new ETF shares by delivering a basket of the fund's underlying securities to the issuer in exchange for a large block of shares called a creation unit, which is generally 50,000 shares. Conversely, they can redeem ETF shares by returning them to the issuer and receiving the underlying securities. This process is conducted in kind, meaning securities are exchanged for shares, not cash. This creation and redemption mechanism is fundamental to how ETFs maintain their market price close to the net asset value of their underlying holdings.
The authorized participants are motivated by arbitrage opportunities. If an ETF's market price trades above the value of its underlying assets, an authorized participant can profit by creating new shares at the lower net asset value and selling them at the higher market price. If the ETF trades below its net asset value, the participant can buy ETF shares cheaply, redeem them for the more valuable underlying securities, and sell those securities. This arbitrage activity provides market liquidity for ETF shares and helps ensure that their intraday market price approximates the net asset value. Other investors, including retail investors using a brokerage account, trade existing ETF shares on the secondary market between themselves.
The true value of an ETF share is its Net Asset Value Per Share (NAVPS), calculated by taking the total value of all the fund's underlying assets, subtracting liabilities, and dividing by the number of shares outstanding. While the market price of an ETF can deviate from its NAVPS due to factors like trading costs and market sentiment, the arbitrage mechanism typically keeps these deviations small. Increased investor demand leading to new share creation is called an ETF inflow, while the conversion of shares back into component securities is an ETF outflow. The efficacy of this arbitrage mechanism is critical for an ETF's share price to accurately track its net asset value.
History and Development of ETFs
The concept of exchange-traded funds originated in 1989 with Index Participation Shares, an S&P 500 proxy that traded on American exchanges but was short-lived due to legal challenges. The first successful product widely recognized as an ETF was the Toronto Index Participation Units, which began trading on the Toronto Stock Exchange in 1990 and tracked the TSE 35 and later TSE 100 indices. Their popularity inspired further development in the United States, leading to the introduction of Standard & Poor's Depositary Receipts, known as SPDRs or Spiders, on the American Stock Exchange in January 1993. This fund, which tracks the S&P 500, became the largest ETF in the world.
The industry expanded rapidly throughout the 1990s and 2000s. State Street Global Advisors introduced sector-specific ETFs in 1998, and Barclays launched World Equity Benchmark Shares in 1996, which later evolved into the iShares line. Vanguard entered the ETF market in 2001 with its Total Stock Market ETF. The first bond ETFs were issued by iShares in July 2002, and the first currency ETF launched in 2005. Regulatory milestones included the SEC's 2008 authorization of actively managed ETFs and the subsequent launch of the first such fund. Leveraged and inverse ETFs emerged in 2006. The market has seen tremendous growth in assets under management, reaching $2 trillion in the U.S. by December 2014, $4 trillion by November 2019, and $5.5 trillion by January 2021.
Key historical developments in ETF products include:
- 1990: Toronto Index Participation Units launch on the TSX.
- 1993: SPDR S&P 500 ETF (SPY) launches.
- 1996: World Equity Benchmark Shares (later iShares) launch.
- 2001: Vanguard enters the ETF market.
- 2002: First bond ETFs launch.
- 2005: First currency ETF launches.
- 2006: First leveraged ETF issued.
- 2008: First actively managed ETF authorized and launched.
- 2021: First Bitcoin futures ETF launches.
- 2024: First spot Bitcoin and Ethereum ETFs begin trading.
Gold ETFs have a distinct history. The Central Fund of Canada, a closed-end fund founded in 1961 and listed on the Toronto Stock Exchange since 1966, amended its structure in 1983 to provide ownership of gold and silver bullion. The first gold exchange-traded product specifically designed as an ETF was Gold Bullion Securities, launched on the Australian Securities Exchange in 2003. The largest gold ETF today is SPDR Gold Shares, which is structured as a grantor trust where each share represents ownership of a specific amount of physical gold.
Types and Strategies of ETFs
ETFs cover a vast range of investment strategies and asset classes. The most common distinction is between passively managed and actively managed funds. Most equity and fixed-income ETFs are index funds that use passive management to replicate the performance of a market index. These indices can be broad-based, like the S&P 500 or the S&P/TSX Composite, or they can focus on specific sectors, market capitalizations, investment factors like value or momentum, or themes like climate change or robotics. Passive ETFs typically have lower management fees because they follow a set index rather than relying on active stock-picking.
Actively managed ETFs employ portfolio managers who make decisions to try to outperform a benchmark or achieve a specific investment outcome. Their strategies can include fundamental analysis, quantitative modeling, or systematic security selection. Some active ETFs use covered call strategies to generate income. Actively managed ETFs generally have higher fees than their passive counterparts. Another category includes factor-based ETFs, which target specific attributes such as quality, low volatility, or high dividend yield. Thematic ETFs focus on long-term trends like cloud computing, electric vehicles, or the gig economy.
Specialized ETF types serve specific investor goals. Leveraged ETFs use derivatives and debt to seek daily returns that are a multiple of an index's performance, while inverse ETFs seek the opposite of the index's daily return. These products undergo daily rebalancing, which can amplify risk and lead to a volatility tax over longer periods. Commodity ETFs hold physical commodities like gold or use futures contracts to track prices. Synthetic ETFs use derivatives like swaps to gain exposure to an index, which introduces counterparty risk. Bond ETFs may focus on government bonds, corporate bonds, high-yield debt, or specific durations.
ETFs in the Canadian Market
The Canadian ETF market is a significant and growing component of the country's investment landscape. The Toronto Stock Exchange lists over 1,000 ETFs, providing Canadian investors with a diverse range of products. According to the Canadian ETF Association, the industry's assets under management are approaching a historic $1 trillion milestone. ETFs have become one of the fastest-growing investment solutions in Canada due to their combination of diversification, transparency, flexibility, and cost efficiency. They help millions of Canadians save for retirement, build wealth, and generate income.
Canadian investors can access a wide array of strategies through domestic ETFs. These include funds tracking broad Canadian indices like the S&P/TSX Composite or the FTSE Canada All Cap Index, which includes small-, medium-, and large-cap companies. Sector-specific ETFs allow investment in areas like financials, energy, or materials, which are heavily weighted in the Canadian market. There are also numerous ETFs providing exposure to U.S. markets, such as those tracking the S&P 500 or NASDAQ-100, and international markets. Fixed-income ETFs covering government and corporate bonds are widely available. Many Canadian financial institutions, including RBC, Scotia, CIBC, and TD, offer their own ETF lineups, often in partnership with global issuers like BlackRock iShares.
The Canadian ETF Association serves as the industry's leading voice, engaging in education, advocacy, and research. CETFA has proposed policy initiatives like the Maple Investment TFSA, a made-in-Canada solution designed to encourage domestic investment and potentially bring back some of the approximately $300 billion Canadians have invested in U.S.-listed ETFs. The association also advocates for reforms to rules like the Allocation to Redeemers policy to strengthen the competitiveness of Canadian-listed ETFs. Canadian ETFs are subject to regulation by provincial securities commissions, and investors should review a fund's prospectus to understand its objectives, strategies, risks, and fees.
Global ETF Market Statistics and Major Issuers
The global ETF market is vast, with the United States being the dominant region. As of recent data, U.S. investors have placed $10.2 trillion in equity ETFs, $2.4 trillion in fixed-income ETFs, and $0.6 trillion in other ETFs. In Europe, the figures are $1.4 trillion in equity ETFs, $0.7 trillion in fixed-income, and $0.1 trillion in other ETFs. The Asia-Pacific region holds $1.9 trillion in equity ETFs and $0.2 trillion in fixed-income ETFs, with major markets including China ($837 billion), Japan ($712 billion), Taiwan ($242 billion), Australia ($212 billion), South Korea ($206 billion), India ($122 billion), and Hong Kong ($75 billion). ETF trading accounts for approximately one-third of the total dollar volume of U.S. stock market trading, 11% in Europe, and 13% in Asia.
The concentration of assets among a few large issuers is significant. In the United States, the largest ETF issuers by market share are BlackRock iShares with 29.5%, Vanguard with 28.7%, State Street Global Advisors with 13.4%, Invesco with 5%, and Charles Schwab with 4%. These firms, along with others like ProShares, VanEck, and WisdomTree, offer products globally. In Canada, major providers include the ETF arms of large banks and asset managers, often distributing products from these global giants. The purchases and sales of underlying assets by large ETFs can significantly affect the prices of those assets, demonstrating the substantial market influence of these funds.
Risks, Costs, and Considerations for Investors
While ETFs offer many benefits, they are not without risks and costs. All ETFs charge an annual Management Expense Ratio, which covers management fees and operating expenses. Although typically lower than mutual fund fees, these costs reduce an investor's net return over time. Trading ETFs also incurs transaction costs, such as brokerage commissions, though many platforms offer a selection of commission-free ETFs. Investors must also consider the bid-ask spread, which is the difference between the buying and selling price of an ETF on the exchange. For less liquid ETFs, this spread can be wider, increasing trading costs.
Investment risks vary by the type of ETF. Market risk is inherent in all funds that hold securities. The value of the ETF will fall if its underlying market declines. Index-tracking ETFs are subject to tracking error, which is the divergence between the ETF's performance and the index it follows. This can be caused by fees, sampling techniques, or the use of derivatives. ETFs that use derivatives, futures, or swaps introduce counterparty risk, where the other party in the contract may default. Leveraged and inverse ETFs are designed for short-term trading and can experience significant losses due to daily rebalancing, especially in volatile markets.
Structural and tax considerations are also important. The arbitrage mechanism that keeps an ETF's price aligned with its net asset value depends on active participation from authorized participants. Disruptions could lead to larger price deviations. In Canada, the tax implications of holding an ETF depend on the type of account it is held in, such as a Registered Retirement Savings Plan, Tax-Free Savings Account, or non-registered account. Generally, ETFs are considered more tax-efficient than mutual funds because investors typically only realize capital gains when they sell their shares. However, distributions from the ETF, such as dividends or interest, are taxable in non-registered accounts. Investors should always read the ETF's prospectus to understand its specific risks, costs, and investment objectives.
Frequently asked questions
How is an ETF different from a mutual fund?
ETFs and mutual funds are both pooled investments, but they differ in key ways. ETFs trade on exchanges like stocks, allowing for intraday buying and selling, while mutual funds are priced and traded only once per day after markets close. ETFs often have lower management fees, especially for passive index-tracking strategies. ETFs are also generally more tax-efficient, as investors typically only realize capital gains when they sell their shares.
What are the main benefits of investing in ETFs?
ETFs offer several core benefits for investors. They provide instant diversification by holding a basket of securities, which reduces the risk associated with owning a single stock. They offer transparency, as most regularly disclose their holdings. ETFs provide trading flexibility, as they can be bought, sold, or sold short during market hours. They are also known for their cost efficiency, typically having lower management expense ratios than actively managed mutual funds.
What is an ETF's Management Expense Ratio (MER)?
The Management Expense Ratio is an annual fee expressed as a percentage of the fund's total assets. It covers the costs of managing and operating the ETF, including portfolio management, administration, and marketing. The MER is deducted from the fund's assets, which reduces the net return to investors. It is a key factor to consider when comparing the cost-effectiveness of different ETFs.
What does ETF stand for?
ETF stands for Exchange Traded Fund. It is a type of investment fund that is also an exchange traded product, meaning it is bought and sold on stock exchanges. ETFs own financial assets such as stocks, bonds, currencies, and commodities. They are priced continuously throughout the trading day, unlike mutual funds, and can be purchased and sold using limit orders. Their shares are created and redeemed in large blocks by authorized participants through an arbitrage mechanism designed to keep the ETF trading close to its net asset value.
Can I buy ETFs in my TFSA or RRSP?
Yes, ETFs can be held in registered accounts such as Tax Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans (RRSPs), as well as in non registered accounts. This is a common practice as ETFs help Canadians save for retirement and build wealth. Holding ETFs in these registered accounts can provide tax advantages, though investors should be aware that trading in ETFs may still be subject to stockbroker commissions. The specific tax treatment depends on the account type and the distributions, such as interest or dividends, paid by the ETF.
Are all ETFs passive index funds?
No, not all ETFs are passive index funds. While most equity and fixed income ETFs are index funds that use passive management to replicate the performance of a market index, other ETFs use active management. Actively managed ETFs involve portfolio managers picking stocks or using strategies like covered calls to generate income. There are also specialized ETFs, such as leveraged or inverse ETFs that use derivatives, and commodity ETFs that may hold physical assets like gold bars. The first actively managed ETF in the United States began trading in 2008.
Sources and further reading
- Exchange-traded fund (Wikipedia) en.wikipedia.org
- What is an Exchange Traded Fund (ETF)? td.com
- Scotia Exchanged Traded Funds (ETFs) scotiabank.com
- What is an ETF? A beginner's guide to exchange-traded ... wealthsimple.com
- Canadian ETF Association, CETFA cetfa.ca
- CIBC Exchange Traded Funds (ETFs) cibc.com
This article explains how things work and is not financial, tax or legal advice. Rules, limits and rates change, so check the current figures with the Canada Revenue Agency, your province or your financial institution before you act.