Special Report: How ETFs Work and Why that Matters to Your Clients
There are the obvious advantages to ETFs you can find in any brochure, but financial advisors can benefit from having a deeper understanding to take full advantage of the investment vehicle’s unique attributes. This is Part One of our five-part ETF Masterclass Special Report.
It’s been nearly 30 years since the very first exchange-traded fund (ETF) debuted in the Canadian market and 25 years since they landed in the U.S. In that time, they have transformed the investing landscape and are now ubiquitous in most client portfolios.
With these products becoming more mainstream, Rich Powers, head of ETF product management at Vanguard, says investors are asking more questions and opting out of manager risk. “[They would] rather invest in an index comprised of growth stocks that’s market-cap weighted, and offered at a really low cost,” he says. Powers says investors want funds with a low turnover and in turn, a lower tax burden, compared to an active strategy with frequent rebalancing.
ETFs are touted for their distinct advantages and merits, namely: transparency, liquidity, and tax advantages. However, genuinely understanding the vehicle and all of the benefits they offer your clients can be a bit more complicated. Here is a refresher.
In a mutual fund, the transaction process goes as follows: Investors wanting to buy in send cash to the fund, and it then buys individual securities, often stocks or bonds. When it is time to sell, it is required to sell the actual underlying stocks or bonds, realize capital gains, and distribute them to the rest of the remaining holders at the end of the year. ETFs, which trade like stocks, imitate this process but are not required to buy and sell the underlying holdings. Instead, the investor buys a share, and it’s traded on the market. When selling, the remaining holders feel no impact.
ETFs also provide tax efficiency during income transfer. John Swolfs, CEO of Inside ETFs, says the share-for-share swap is not considered taxable, “so you’re able to take your low-cost securities and your high-cost securities, flush out the high-cost securities, and bring in the low-cost bonds,” he says. “But because they’re both technically stocks, that’s an income transfer, and the government doesn’t view that as a taxable event.”
Similarly, he says “You’ll be a better investor if you really know how the create-redeem function of the ETF works. It allows low-cost securities to be scraped out, keeping the cost basis of the fund high, which means you’re less likely to see a capital gains distribution,” he says. “Just the mechanics alone give you a tax advantage over a more traditional fund approach.”
For investors that require more liquidity in their portfolio, an ETF is a strong option. The structuring of ETFs makes maintaining liquidity easier for investors in several ways. First, there is typically broad diversification, and unlike mutual funds, which disclose their holdings every 90 days, ETFs make this information available in real time. The real-time advantage also lends itself to trading, which can be done all throughout the day, compared to mutual funds, which are only able to trade at close of market.
Because, at its core, liquidity hinges on the agility and speed by which an investor can buy or sell something, ETFs remain useful for investors who need to raise cash quickly, and they can use them to enter or exit a position quickly. Liquidity is, however, impacted by several factors that all investors need to bear in mind. The investment environment still bears heavy influence on liquidity, as does the trading volume of individual securities in the ETF and the securities themselves.
Patrick Sweeny, founding partner of Symmetry Partners, says advisors need to employ due diligence on ETF strategies and the provider or sponsor. Due diligence also comes down to studying its liquidity, bearing a simple thesis in mind: “Do the due diligence on ‘is it liquid enough for them to move clients into this product and get them out of this product when they need to,’” he says.
After said due diligence, “You can come to your own conclusions as to if this is a viable strategy that’s deserving of your attention,” says Sweeny.