There are a number of different types of ETFs. Many track the performance of an underlying index or benchmark. There are a number of different types of indices as well. ETFs have evolved to include some that do not passively track an underlying index or benchmark.
Passive Index Tracking ETFs
Index-based ETFs are the most common type of ETF. These ETFs are designed to replicate and passively track the performance of an underlying benchmark index. They mirror the index by investing in the component securities of the index, that is, they hold the same mix of investments as the index. Index ETFs may track a broad-based equity index such as the S&P/TSX Composite Index or the S&P 500 Index. Or, they may track a sector specific index such as the S&P/TSX Global Mining Index. Still others track indices that offer exposure to fixed income, such as the DEX All Corporate Bond Index.
Amongst passive index-based or index-tracking ETFs, it is important to note that some ETFs will use full replication, while others may opt for a methodology known as “sampling”. Full replication is generally the preferred starting point. Sampling strategies arise from a desire to replicate most of the underlying index, while seeking to avoid some of the securities comprising the index. Access to some of them may be deemed to be challenging, or their inclusion may be deemed to subject the ETF to excessive market impact or liquidity related risks. If these outweigh full replication benefits, sampling might be used.
The return on the ETF should closely track that of the underlying index, although different types of benchmarks can be expected to deliver very different returns. For example, the S&P/TSX 60 Index uses a market-capitalization weighted methodology, meaning the larger companies make up a much higher percentage of the index than the smaller companies. Some ETFs may track an S&P/TSX 60 index which is equal weighted, meaning all the companies have equal representation in the index, irrespective of their size. Although these two benchmarks may seem similar, they could generate very different returns.
These types of ETFs tend to have the lowest management expense ratios (MERs) to cover management fees.
Actively Managed ETFs
Some ETF providers offer actively managed ETFs. These ETFs are the closest to a traditional (actively managed) mutual fund. These ETFs have a portfolio manager who is making investment decisions and selecting individual securities, either with the objective of outperforming the market rather than passively tracking a particular index, or with meeting pre-specified investment objectives. Unlike an index-based ETF, a portfolio manager of an actively managed ETF may actively buy or sell components in the portfolio on a daily basis without reference to an index.
These ETFs tend to have higher than average MERs to cover management fees.
Quasi-Passive or Quasi-Active ETFs
Some ETFs blur the line between passive index tracking and active management. Enhanced index, rules-based or strategy-based ETFs exhibit both passive and active management features as they track custom made indices that incorporate active strategies. For example, some start with a broad index and then alter the weighting of securities in the portfolio according to certain rules. Others select investments based on fundamentals such as earnings or valuations. Still others filter out securities that do not meet certain criteria. One example would be a methodology that selects only companies that have a certain track record as pertains to dividend payments.
As with all investment decisions, investors should undertake their own due diligence to determine how the indices are created, what types of strategies are incorporated, and their expected performance. ETFs with seemingly similar benchmarks can actually be quite different, which can result in significant differences as pertains to returns.
Leveraged and Inverse ETFs
Leveraged, Inverse and Leveraged Inverse ETFs may be considered by some to be index-based because they seek to deliver daily returns that are multiples or inverse multiples of the performance of the benchmark index they track.
Leveraged ETFs are designed to seek daily investment results to provide a multiple of the daily performance of an underlying index or benchmark, for example, two times or 200% the return of the index or benchmark. They are not designed to provide that same multiple of the return over the mid or long term. Investors should be aware that, while leveraged ETFs typically achieve their stated objective of a multiple of the daily performance of an underlying index on a daily basis, their returns can vary considerably from that stated objective if held for a period longer than one day due to the compounding effects of daily rebalancing.
Inverse ETFs are designed to seek daily investment results that correspond to the inverse daily performance of their underlying index or benchmark. So, when the index or benchmark goes down in value on a given day, the inverse ETF will correspondingly go up in value for that given day. Conversely, when the index or benchmark goes up in value on a given day, the inverse ETF will correspondingly go down in value for that given day. Inverse ETFs can be an effective hedging tool. The performance of inverse ETFs held over a period greater than one day can also vary from a straight 1:1 inverse exposure over said period. The potential differential may be less than that in the case of a leveraged ETF, but needs to be noted nonetheless.
Note that some leveraged ETFs are also inverse in that they use leverage to track a multiple of the inverse or opposite of the return of an underlying benchmark.
To meet their investment objectives, leveraged and inverse ETFs use a variety of derivatives or futures contracts designed to earn either a multiple of the return for a given index or a negative or inverse multiple of the underlying index. Leveraging increases risk in that both gains and losses will be magnified. The maximum loss can be up to the value of the original investment.
Leveraged and inverse ETFs are generally intended for use in short-term investment strategies; they are not intended for investors who are looking to hold positions in a security beyond the short term, thus making them potentially unsuitable for long-term investors. Over time, a leveraged fund can drift from its benchmark due to the compounding effects of daily rebalancing, especially during periods of market volatility. Therefore, the return on these ETFs for periods longer than a single day will not correlate with the return of the underlying benchmark. Accordingly, significantly more risk is associated with these types of ETFs than with index-based ETFs. It is important that investors clearly understand the nature and risks of any particular ETF prior to investing; if necessary, seek the assistance of a qualified investment advisor.
Leveraged and Inverse ETFs tend to have higher than average MERs.
Commodity ETFs provide exposure to commodities such as energy (e.g., natural gas or oil), precious metals (e.g., gold, silver or platinum), or livestock and grains, either by (i) holding the physical commodity directly, (ii) tracking the performance of the spot market price through physical forward contracts, or (iii) tracking the performance of commodity futures contracts. ETFs that hold the physical commodity provide exposure to the spot price of the commodity. Most ETFs of this type are precious metals ETFs and metal bars owned by the fund are stored in secure vaults around the world. ETFs that provide exposure to futures contracts take care of the requirement of buying, selling and rolling them so that the investor does not need to do so. Most futures contracts are settled, swapped or rolled before the expiry date to avoid taking physical delivery of the actual commodity. Most commodity indices are futures price indices, reflecting a change in the price of the commodity futures, not in the commodity spot price.
When investing in futures-based commodity ETFs, investors should be aware of the basic shape of the futures curve. When the futures price is higher than today’s spot price, the curve is said to be in “contango”. The inverse, i.e., the futures price is below the expected spot price, is referred to as “backwardation”. Typically, a futures-based commodity ETF benefits from backwardation. Since ETFs have to roll futures contracts to avoid physical delivery of the commodity, the fund will profit each time it rolls to a cheaper, later dated futures contract. Conversely, in the case of contango, the fund will incur losses each time it rolls to a costlier, later dated contract. In the situation of contango, futures-based commodity ETFs can experience losses even if the underlying commodity’s spot price rises. An environment where futures contracts are rolled over into different futures contracts of longer maturity at a higher cost is referred to as a "negative roll yield" environment.
Commodity ETFs should not be confused with equity-based commodity ETFs which hold a portfolio of shares of commodity producers. These funds do not track a commodity’s spot or futures price movements. The performance of these companies is not always correlated to the price of their underlying commodity. In the case of some commodities, equity-based commodity ETFs may be the only way to gain exposure to the assets in an ETF form as physically backed or futures-based ETFs may not be available. Equity-based commodity ETFs track the performance of companies, and certain company related factors which may have nothing to do with the performance of the underlying commodity can negatively affect the performance of the ETF. Such factors might be mismanagement, corruption, environmental disasters or lawsuits, amongst others.
Physical Replication and Synthetic Replication
ETFs can generally be broken down into two broad categories. Physically replicated ETFs hold the constituents of an index – they are based on full or partial replication of the index; synthetic ETFs on the other hand use derivatives to deliver returns. Often synthetic ETFs are used in cases where physical replication is not possible, or expensive, such as commodity ETFs.
In cases where physical replication is possible, synthetic alternatives to traditional index ETFs exist. The ETF provider could enter into a derivatives transaction, such as a total return swap, with a counterparty. The counterparty agrees to deliver the return on the chosen benchmark in exchange for cash or mutually agreed upon assets. Swap-based ETFs may be attractive to certain investors because they may potentially offer lower costs than their physical alternatives, and deliver less tracking error. The trade off is the risk of counterparty failure. In Canada, counterparties are Canadian chartered banks or affiliates thereof. Canadian regulation limits exposure to any one counterparty to 10% of the net asset value (NAV) of the fund and requires that the counterparty to any total return swap or other derivative maintain a minimum credit rating as prescribed in National Instrument 81-102 – Mutual Funds of the Canadian Securities Administrators. In Canada, total return swap based ETFs are collateralized in cash or cash equivalents.
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