Understanding ETFs

Whether you’re investing on your own or working with a financial advisor, our TD Exchange-Traded Funds (TD ETFs) can help you lower costs and increase your return potential.

What is an ETF?
How ETFs work

What is an ETF?

Exchange-Traded Funds (ETFs) are investments that seek to combine the diversification of mutual funds with the trading flexibility of securities.

Like mutual funds, ETFs invest in a basket (i.e. portfolio) of securities such as stocks, fixed income or commodities. But, unlike mutual funds, ETFs are bought and sold on a stock exchange. This means their pricing changes throughout the day. In contrast, mutual fund prices are determined daily after the close of the stock market. Additionally, mutual fund purchases and sales are processed by the fund company.

What are the potential benefits of ETFs?

Core benefits include:

Diversification: Through a single ETF, investors can gain instant diversification to a portfolio of different securities. Holding a mix of securities that have a low correlation (i.e. do not behave in the same way) may potentially stabilize the performance of an ETF and your investment portfolio. Equally important, diversification can help minimize the risk of loss – if a few investments perform poorly, others held in the portfolio may be doing better.
Transparency: The holdings inside an ETF are published daily on the issuing company's website. Investors will know exactly what they're invested in. This can help you diversify your portfolio - i.e. avoid owning duplicate investments. Or, if you're invested in an index ETF, you can easily see how closely it mirrors the benchmark index it's designed to replicate.

Trading flexibility: Since ETFs are listed on stock exchanges, investors have the flexibility of buying and selling them when the market is open. Investors can exercise some control on the price they get – for example, by placing a limit order (an order to buy/sell a security at a specific price or better). Finally, with ETFs being listed on exchanges, investors can access ETFs across the globe – they are not limited to ETFs from Canada.
Lower costs: Compared to other investment funds, ETFs tend to have lower management fees and operating costs. Lower fees mean more of your savings are invested which - with the benefits of compounding – can improve your return. However, as ETFs are bought and sold on an exchange, remember there can be brokerage commissions charged for each transaction.

ETFs vs. Mutual Funds vs. Stocks - What are the differences?

The table below shows the basic similarities and differences between ETFs, mutual funds and stocks.


	Mutual funds	ETFs	Stocks
Underlying Securities	Securities, fixed income, commodities, currency, derivatives.	Securities, fixed income, commodities, currency, derivatives.	None
Diversification	Yes	Yes	No
Pricing	Price is calculated at the end of day. It's based on the market value of the investments in the fund divided by the number of units outstanding (i.e. Net Asset Value Per Share - NAVPS).	Based on the bid and ask prices. Bid is the highest price investors will pay to buy it. Ask is the lowest prices investors will sell it. Prices change throughout the market trading day.	Based on the bid and ask prices. Bid is the highest price investors will pay to buy it. Ask is the lowest prices investors will sell it. Prices change throughout the market trading day.
Eligible for pre-authorized contribution plan "PAC"³	Yes	No	No
Management Expense Ratio	Mutual funds charge a management fee and have certain operating costs, for the ongoing operation and administration of the fund. Together, these fees make up the management expense ratio (MER), which is the total of the management fees and operating costs expressed as a percentage of the fund's total assets.	ETFs charge a management fee and have certain operating costs, for the ongoing operation and administration of the fund. Together, these fees make up the management expense ratio (MER), which is the total of the management fees and operating costs expressed as a percentage of the fund's total assets.	None
Management fees	Often between 1% to 3%	Typically lower than 1%	None
Transaction costs/fees	Several purchase options, some do not incur commissions. No commission charged on selling mutual funds.	Brokerage commission charged on buying and selling ETFs.	Brokerage commission charged on buying and selling stocks.
Rebalancing costs	Typically no costs to switch between funds.	Brokerage commissions (but typically less expensive than stocks).	Brokerage commissions on additional stock purchased or sold to rebalance portfolio.
Distributions	Distributions and interest income can be automatically reinvested at no additional costs through a dividend reinvestment plan (DRIP).	Distributions and interest income can be automatically reinvested through a DRIP, provided total distributions are enough to purchase a whole ETF unit.	Distributions and interest income can be automatically reinvested through a DRIP. Depending on the stock, total distributions do need to be enough to purchase a whole unit - a fraction of the share can be purchased.

Understanding active vs. passive management

With actively-managed ETFs, the Portfolio Manager picks securities based on their research and strategies. They seek to own a basket of securities that is different from an index in an attempt to outperform the index.

For passively managed ETFs, the Portfolio Manager seeks to hold a basket of securities similar to the benchmark index it's attempting to replicate. For example, the ETF would seek to hold a similar basket of securities as the S&P/ TSX Composite Index or the Dow Jones Industrial Average Index.

What's the difference between Index Funds and ETFs

This question is raised frequently by investors and it's easy to understand why – the two investment solutions can be similar in some ways.

Index Funds are mutual funds that typically track a specific market index such as the S&P/TSX Composite Index. Broad-market ETFs also do the same. For both investments, the Portfolio Managers attempt to create a portfolio of securities that replicate the composition and performance of a given index (i.e. passive management).

Where the two differ is in the costs, and how they are bought and sold. As Index Funds are mutual funds, they can have higher fees than ETFs. And while mutual funds are purchased and sold through the issuing investment management company, ETFs are traded on stock exchanges.

Buying and selling ETFs can involve brokerage transaction fees, while purchases and redemptions of Index Funds are less likely to incur fees.

How do you buy ETFs?

Since ETFs are listed and traded on stock exchanges, they can be bought and sold through a direct investing brokerage or an advisor.

To invest in ETFs, you'll first need to open an account. Remember, you can hold ETFs in a tax-free-savings account (TFSA), Registered Retirement Savings account (RRSP), and non-registered accounts. The tax consequences for holding ETFs in each type of accounts will vary. Speak to an advisor or a tax specialist for more information.

Several types of direct investing services are available. You can speak directly on the phone to a representative, who can help you place an order for a flat fee. You may also have the option of placing the order yourself online, often for a lower flat fee.

TD Direct Investing offers both telephone and online services – Access TD Direct Investing website.

Alternatively, you can also invest in ETFs through an advisor. While this approach will include advisory fees and/or commissions, it may be worthwhile if you need guidance on selecting the right ETFs for your overall portfolio. Remember, a diversified mix of multiple securities can help you achieve your investment goals with lower risk. Learn about TD Wealth – personalized planning and advice.

¹ 16 amazing things invented by Canadians, CBC News, Posted Jul. 10, 2017, Tracey Lindermand.

² The Exchange Traded Fund Manual, Second Edition, John Wiley & Sons Inc., 2010, Gary Gastineau.

³ A simple automatic plan that transfers money from your bank to your investment account to purchase units on a regular basis.

The above information about the Tax-Free Savings Account is based on the information currently available from the Canadian government. To learn more or to check for updates, visit the TFSA information page on the Canada Revenue Agency website.

A look at the ETF creation and redemption process, the roles of a Designated Broker and Market Maker, plus how they affect ETF pricing, transparency and tax efficiency.

How ETFs are Created

ETFs are made through a creation and redemption process that takes place in the primary market - a market where all securities are created.

When a fund company decides to launch ETFs, they will work with a designated broker, which is typically a bank or securities dealer.

The designated broker facilitates the creation of ETFs by delivering, to the fund company that's managing the ETF, a basket of the underlying securities that make up the ETF. In return, the fund company will issue ETF units to the broker that can be sold to investors through the stock market (i.e. the secondary market).

The designated broker will also act as a Market Maker by buying and selling units on the stock exchanges as needed to help keep the trading prices close to the net asset value (NAV), and to keep a reasonable spread for the units (the difference between the bid and ask price, explained below).

If the designated broker runs out of ETF units, they can get more by delivering the basket of securities to the fund company and receiving additional ETF units. This happens when there's more demand for the ETF than supply.

But if there's more supply, a designated broker can "redeem" units by delivering ETF units to the fund company and receiving a basket of securities in return. This process reduces the number of units outstanding.

In practice, there's typically more than one designated broker for an ETF which helps to ensure the units are trading close to their true value (i.e. NAV).

How ETFs are Priced

ETFs have both a NAV (Net Asset Value) and a market price. The NAV is the total value of the ETF's underlying securities based on the most current market closing prices.

Ideally, the NAV should match the ETF's market price. But the supply and demand of the ETF can also cause it to trade above its NAV (i.e. at a premium price) or below (i.e. at a discount price).

If the gap between the market prices and the NAV gets too wide, the Market Maker can step in to redeem or create ETF units in the primary market to help bring the market price closer to the NAV.

In some cases, due to differences in market trading hours for ETFs that hold international securities, the market prices of the securities may not be fully reflected in the ETF.

For example, an ETF with Japanese equities that's trading in Canada when the Japanese markets are closed may have a market price that differs from the closing values of the underlying Japanese securities, due to some recent news or market sentiment. But when the Japanese market reopens those underlying stocks will be valued higher or lower.

Last, if the underlying securities of an ETF are less liquid (i.e. cannot be easily sold or bought in the market) the additional costs to hold or sell these securities may affect the trading prices of the ETF.

What are the costs of owning ETFs?

Costs of owning ETFs include management fees, operational expenses and trading fees.

ETFs charge a management fee and have certain operating costs for the ongoing operation and administration of the ETF. Added together, these fees make up the management expense ratio (MER), which is the total of the management fees and operating costs expressed as a percentage of the ETF's total assets.

Also, buying and selling ETFs on a stock exchange can incur brokerage fees/commissions.

What are the bid and ask prices?

The Market Maker facilitates the purchase and sale of ETFs by investors. When investors want to buy ETFs, it will post the ask price (price to purchase) – which is often a little higher than the ETF's NAV. And, when investors want to sell, the Market Maker will buy it back ETFs at its bid price – which can be slightly lower than the NAV.

The difference between the bid and ask price is the bid-ask spread.

If a number of investors are buying and selling an ETF in the secondary market amongst themselves, their quotes to buy and sell can often cause the bid-ask spread to narrow from what the Market Maker is quoting.

What makes ETFs tax-efficient

Some reasons ETFs are tax efficient include:

Low security turnover in broad-market ETFs
Broad-market ETFs which track a specific index, such as the Solactive Canada Broad Market Index, seek to hold a similar basket of underlying securities as an index. Since there are seldom changes in the securities listed on an index, there will also be minimal changes in the securities held in the ETF. This means fewer securities sales and taxable transactions.
How ETFs are traded on a stock exchange
A large portion of trading in ETFs happens on a stock exchange between two investors (i.e. buyers and sellers). The fund company is generally not directly involved and does not need to buy or sell securities held in the ETF portfolio (i.e. transactions that trigger a taxable event) to finance purchases or sales by investors.

This is different from a traditional mutual fund where all requests to buy or sell the traditional mutual fund end up with the fund having to either buy or sell underlying securities, which will trigger a taxable event such as capital gains which is passed onto the investors.

Altogether, ETFs will have fewer taxable transactions than traditional mutual funds providing investors with a more tax-efficient investment.

Read: How Exchange-Traded Funds are Taxed

How ETFs are used in a portfolio

One of the important steps in considering Exchange-Traded Funds (ETFs) for your portfolio is understanding the role and potential benefits associated with different ETF categories and products. Here is some information to help you get started.

Broad-Market Index ETFs

Broad-market indexes form the blueprint of this ETF category.

An example of a broad-market index is the S&P/TSX Composite Index, which is a representation of the Canadian stock market – and by extension, the country's economy. This index holds approximately 250 securities from the largest Canadian companies that trade on the Toronto Stock Exchange (TSX). Through a single ETF, investors can get instant diversification to hundreds of securities across different industries that would otherwise be costly and time-consuming to acquire individually.

These ETFs are often passively managed, meaning the Portfolio Manager attempts to replicate an index in composition and performance.

Here are a few ways broad-market ETFs can play a role in an investment portfolio:

Core asset allocation: These ETFs can be used to build an investment portfolio's strategic long-term asset mix of equities (stocks) and fixed income (bonds) – the foundation of many investment portfolios. They can also help make it easy to achieve diversification within each asset class.
Tactical or thematic investing: These ETFs may help investors to take advantage of potential opportunities in the market by allowing them to target specific sectors, regions or investment strategies.
Cash equitization: ETFs can be used as a temporary investment to overcome "cash drag" and negative returns from holding too much cash for too long. This technique tends to be more effective with highly liquid ETFs that can be sold quickly, and at prices reflective of their true value.

Quantitative ETFs

Quantitative ETFs engage in factor investing, which means they focus on groups of securities with specific characteristics that may account for why a stock is performing well (e.g. achieving higher returns or lower volatility) relative to a broad-market index.

TD Asset Management (TDAM) views some of the more common factors to include: small-cap status, value, quality, momentum and low-volatility (learn more about these factors). Each factor has particular characteristics. For example, a portfolio constructed using securities with a low-volatility factor can be expected to have similar returns as a broad market index over time, but with fewer ups and downs.

Here are a few considerations when selecting Quantitative ETFs:

Interested in minimizing overall portfolio risk? A Quantitative ETF focused on a low-volatility factor may help deliver more consistent returns over time.
Seeking to outperform a market-capitalization index? You may wish to consider a multi-factor Quantitative ETF. These can enhance diversification and may position your portfolio for higher growth relative to a market-capitalization index, which is an index that's weighted according to the market size of the company (e.g. bigger companies have larger representation on this type of index).
Seeking greater diversification and the potential for better risk-adjusted returns? Consider Quantitative ETFs that include multiple factors which may help to reduce the cyclical nature of single factor strategies and thereby help to reduce risk.

Active Fundamental ETFs

These ETFs seek to outperform a broad-based index or deliver a specific outcome to investors. The extensive research capabilities at TDAM provide a foundation for our ETF investment strategies and help Portfolio Managers identify high-quality companies that exhibit long-term leadership in their respective markets.

A Portfolio Manager will focus on specific sectors or investments to help meet a fund's long-term objectives.

Some of the ways Active Fundamental ETFs can add value to your portfolio include:

Seeking to capitalize on market inefficiencies? Research capabilities help our investment teams to find mispriced, undervalued securities which may lead to returns that outperform the broader market.
Navigating complex and inefficient asset classes? Preferred shares, which are securities that provide regular dividends to investors, are quite complex to understand but continue to be popular with investors due to its potential to generate higher regular income than bonds. However, each preferred share comes with its own set of provisions, features and risk levels. Portfolio Managers who can understand these nuances (i.e. the fine print) can better determine the potential real return of the preferred shares.
Seeking to avoid unintended risks of fixed income indexes? Passive fixed income indexes are weighted according to the debt size of the issuer (government and corporations). Issuers with the most debt have a larger representation on the index, so an investor's exposure could be skewed to a few issuers with a high debt load. Compare this with an active investment strategy, where the Portfolio Manager can be selective with the fixed income securities they choose for an ETF. As a result, their ETF portfolios can be diversified according to income, return potential, and sensitivities to different market or economic conditions (such as interest rates).

The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual's objectives and risk tolerance.

Commissions, management fees and expenses all may be associated with investments in exchange- traded funds (ETFs). Please read the prospectus and summary document(s) before investing. ETFs are not guaranteed, their values change frequently and past performance may not be repeated. ETF units are bought and sold at market price on a stock exchange and brokerage commissions will reduce returns.

TD Asset Management Inc. is a wholly-owned subsidiary of The Toronto-Dominion Bank.

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