Demystify exchange-traded funds

We’ve been hearing a lot about exchange-traded funds over the last few years. And for a very good reason! This investment vehicle can prove very useful in certain circumstances. While the comparisons with mutual funds¹ are numerous and relevant, they are often misconstrued.

The first assertion to explore is that exchange-traded funds (ETFs) always track a market index through index or passive management², while mutual funds (MFs) are managed actively³. This misconception has led to a great deal of misunderstandings when comparing these investment vehicles. 

Here is some important information to better understand the nature of ETFs and their differences and similarities with MFs. Present in the economic landscape for several years, ETFs are now well-established and deserve that we examine their characteristics and bust certain myths that have persisted over the years. 

An exchange-traded fund (ETF) is an investment fund whose units are traded on a stock exchange like any regular stock⁴. Much like mutual funds (MFs), ETFs are legal entities, “containers” that can hold anything, as long as the liquidity of the instruments added (e.g. stocks, bonds, derivatives, ETFs, MFs, etc.) is kept above a minimum threshold, and they can be managed through various investment strategies.

Despite their similarities, ETFs and MFs differ in many ways. Here are some of their key features for a better comparison. 

Management approach
MFs and ETFs can both be managed using an active³ or passive (index)² portfolio management strategy, which is a strategy that may seek to track the performance of a market index.

Transactions
Like a regular stock, an ETF can be traded on the stock market during trading hours, while transactions on MFs take place over-the-counter, once a day, after the market closes. This is the key difference between the two vehicles.

Value
A MF trades at a price that reflects the fair value of its underlying assets at market closing. While the value of a MF is only affected by the price of the securities it holds, the price of an ETF is dependent both on the value of the securities it holds and on the law of supply and demand, as the fund is traded like a stock. This price determination factor can lead to a tracking error⁵ between the real value of the underlying securities and the value of the ETF. This divergence is usually minimal and insignificant. However, when the difference becomes too important, arbitrage opportunities⁶ emerge, and capitalizing on them will bring back the tracking error within a more normal range.

Advice  
With regard to MFs, advice is either included or tacked on as a supplement through fees. For ETFs, advice is only provided for a fee. 

Cost
With both vehicles, the cost will depend on the investment strategy that’s been chosen. For example, it is more expensive to manage emerging market stocks than Canadian bonds and active management is costlier than passive management. Whether the MF is offered with or without services will also impact its cost. For an ETF, aside from the type of strategy, the brokerage fees⁷ and bid-ask spread⁸ will also affect the cost. 

Characteristics of ETFs and MFs

Source: FÉRIQUE Funds Management

Of all the differences between ETFs and MFs, the cost is the one most frequently cited. Returns also get people talking. Some investors swear that ETFs perform much better than other funds but how do they really stack up?

Similar costs when compared on the same basis
One of the most common misconceptions is that ETFs cost significantly less than MFs. The truth is that when compared on the same basis, their prices are very similar. Setting side by side the management expense ratios (MER) of the different structures of the funds (with and without services) and comparing the cost of an ETF with that of its equivalent MF shows that these investment vehicles are equivalent. Moreover, an ETF’s brokerage fees and bid-ask spread must also be taken into account when calculating its cost. 

Commensurable returns
Since the same assets can be invested in both MFs and ETFs at similar costs for equivalent strategies, the returns achieved or sought are fairly similar. The relative performance between these two investment vehicles is not at stake when they are compared based on the same parameters.

MF or ETF, which one is better, then?
The costs and returns discrepancies between ETFs and MFs are directly tied to the underlying investment approach chosen (whether active or passive) and the type of distribution method preferred by the fund company (with or without services).

If ETFs and MFs are two vehicles providing the same products at a similar cost, the question remains: why did the financial industry create ETFs as an alternative to MFs? 

The answer is that it allows fund companies to offer an investment vehicle suited to different distribution models and distribute more broadly their products.

For example, FÉRIQUE Fund Management products are distributed to clients through FÉRIQUE Investment Services (a mutual fund broker)¹⁰. Meanwhile, in other companies, the products may be distributed through branches, discount brokerage¹¹ or independent brokers¹².

The licences required to provide advice related to ETFs and MFs are different in all the above situations.

Offering MFs or ETFs is normal and legitimate and in line with fund companies’ distribution strategies.

Source : FÉRIQUE Funds Management

As we can see, ETFs and MFs have a lot in common, and the discrepancies with regard to costs and returns stem from the choices investors make. When deciding which investment vehicle suits you best, it is important to compare them based on the same parameters, such as advice provided and management strategy. These parameters may have an impact on the cost and performance of your investments. 

Providing advice, an integral part of FÉRIQUE Fund Management’s business model!
As a fund company, FÉRIQUE Fund Management offers MFs, since we favour a business model that includes the provision of advice and only distribute our products through FÉRIQUE Investment Services. Thanks to our non-profit status that allows us to return benefits to our clients, FÉRIQUE Fund Management offers mutual funds with some of the lowest MER of the industry in Canada¹³, while still including services. 

For us, accelerating financial autonomy means serving our clients. This approach promotes better saving behaviours and prevents impulsive decisions.