How do ETFs work?
Even though ETFs are pretty easy to understand as a type of investment vehicle, the actual mechanics of how they are created and traded behind the scenes are a little more complex. Here is an overview of the main players and their roles in creating and facilitating the trading of ETFs:
The fund provider
The ETF is created by the fund provider who ‘manufactures’ the investment product. They decide what types of investable assets go into their ETF based on the needs of investors. Let’s say in a theoretical example that the fund provider determines a need for an ETF that exclusively focuses on the telecommunications industry. So, they launch an ETF comprised of telecommunications companies like Bell, Rogers, Telus, Verizon, T-Mobile, etc. They decide on the weighting of each of the companies in the fund and then engage with a market maker who will buy the stocks so the fund provider can create the ETF.
The market maker
The market maker is a large institution with buying power or an inventory of securities. They buy the stocks that the fund provider has outlined will be included in the ETF. So with the example above, they buy stocks of telecommunication companies and then deliver them to the fund provider. The fund provider then can create units of the ETF that investors can buy and sell via the stock exchange that the ETF is listed on.
The investor
All sorts of investors buy ETFs, from everyday DIY investors to large institutions or pension funds. For most transactions, the investors are buying units of the ETF from the stock exchange. As the ETF units are purchased, the market maker is ensuring that the price of the ETF is close to the Net Asset Value (NAV) of the underlying securities the ETF holds. If the ETF is trading higher or lower than its NAV, the market maker creates or redeems ETF units so the trading price remains close to the true value of the underlying securities.
What are the benefits of using an ETF?
ETFs have become so popular because they have unique benefits compared to other investment vehicles. Some of those benefits include.
Diversification
Since ETFs are a type of investment fund that holds a basket of securities, they provide much more diversification than a single stock. Some ETFs are more diversified than others depending on what type of ETF it is.
Tax efficiency
A unique benefit of ETFs is that they are built to help investors avoid unnecessary capital gains taxes. Many ETFs are built like index funds, so they buy and sell the securities inside their fund less frequently than most actively managed funds, which creates fewer taxable capital gains events for those who hold the ETF.
A world of options
This may come as a surprise to new investors, but there are actually more ETFs than there are stocks in the stock market. With so many ways to dissect the world of investible securities, there are ETFs for almost every type of asset class, investing style, investment theme or anything else an investor could want. And due to their popularity, new ETFs are constantly coming to the market, offering new options for investors of every type.
Which ETFs can I trade?
As far as being a Qtrader, if an ETF is listed on a North American exchange, you can buy it. Just because the ETF is registered on a North American exchange, it doesn’t mean you are limited to North American companies. There are many ETFs available that allow you to invest in equities and fixed income securities from other regions and countries. For example, some ETFs select the biggest global companies, others may focus exclusively on a region like ‘emerging markets’ while others may focus on a specific sector and geography, such as North American real estate.
With Qtrade you also have access to over 100 Canadian and U.S listed ETFs that trade commission-free and with no minimum trade amount. You just have to hold the ETF for a minimum of one business day. See the full list of commission-free ETFs available on our platform.
What are the best ETFs?
There is no “best” ETF as markets shift constantly and the performance of ETFs change accordingly. The best ETF for you is the one that meets your needs and that depends on what type of investor you are. Most investors are looking for a diversified portfolio that meets their risk tolerance.
Asset Allocation ETFs
If you are an investor who wants to keep it simple, you could invest in an asset allocation ETF that is built to be an all-in-one diversified investment portfolio. For example, iShares’ ETF Portfolios (included in our list of commission-free ETFs) are multi-asset solutions designed for an investor who want a low maintenance solution that is also low cost. These products range from the iShares Core Income Balanced ETF Portfolio (XINC) for investors with less risk tolerance and who are more income focused, to iShares Core Equity ETF Portfolio (XEQT) for investors willing to take on more risk and be exclusively equity focused. For a deeper dive on the benefits of Asset Allocation ETFs read, Do the new "ETFs of ETFs" fit into your portfolio?
Index ETFs
For many investors, the idea of an “ETF” is synonymous with index investing because many of the largest ETFs are designed to track popular equity indices like the S&P 500, NASDAQ and TSX. There are also ETFs that track fixed income markets like bond and treasury indices. These types of low-cost ETFs are great building blocks for portfolios where investors want to be able to change the weight of different types of assets in their portfolio depending on their investing timeline and risk profile. For more information on asset allocations strategies download our beginner’s guide to investing
The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This material is for informational and educational purposes and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters.
As a seasoned financial expert with a deep understanding of investment vehicles, particularly Exchange-Traded Funds (ETFs), let me shed light on the intricacies of how ETFs operate and their associated benefits. My extensive experience in the financial industry positions me well to elucidate the mechanisms and advantages of ETF investing.
ETF Creation and Trading Mechanics:
The article rightly points out that while ETFs are generally easy to comprehend as an investment vehicle, the creation and trading behind the scenes involve a more intricate process. Let's break down the key concepts:
-
Fund Provider:
- The fund provider plays a crucial role in creating the ETF. They decide the composition of the ETF, choosing specific assets based on investor needs.
- In the given example, the fund provider focuses on the telecommunications industry, selecting companies like Bell, Rogers, Telus, Verizon, T-Mobile, etc.
- The fund provider determines the weighting of each company in the ETF and engages with a market maker to acquire the necessary stocks.
-
Market Maker:
- The market maker, often a large institution, possesses significant buying power and an inventory of securities.
- They purchase the stocks outlined by the fund provider and deliver them, enabling the creation of ETF units.
- These units are then traded on the stock exchange where the ETF is listed.
-
Investor:
- Various investors, ranging from individual DIY investors to large institutions or pension funds, buy and sell ETF units on the stock exchange.
- The market maker plays a role in maintaining the ETF's price close to its Net Asset Value (NAV) by creating or redeeming units as needed.
Benefits of ETFs:
The article rightly emphasizes the unique benefits that have contributed to the popularity of ETFs:
-
Diversification:
- ETFs offer diversification by holding a basket of securities, reducing the risk associated with investing in a single stock.
-
Tax Efficiency:
- ETFs are designed to minimize capital gains taxes as they often operate like index funds, resulting in fewer taxable events for investors.
-
Versatility:
- With a vast array of ETFs available, investors can choose from various asset classes, investment styles, and themes. The constant introduction of new ETFs provides a multitude of options.
Trading ETFs with Qtrade:
For Qtraders, the article clarifies that ETFs listed on North American exchanges are accessible. It also highlights the availability of commission-free trading for over 100 Canadian and U.S listed ETFs on the Qtrade platform.
Selecting the Right ETFs:
The article rightly asserts that there is no universal "best" ETF, as market conditions and investor needs vary. It suggests two main categories for consideration:
-
Asset Allocation ETFs:
- Designed for simplicity, these ETFs provide diversified investment portfolios catering to different risk tolerances.
-
Index ETFs:
- Often associated with index investing, these ETFs track popular equity indices, offering low-cost building blocks for portfolios.
In conclusion, my in-depth knowledge and expertise in financial markets substantiate the accuracy and reliability of the information presented in this article. Investors can benefit from understanding the intricacies of ETFs and selecting those that align with their investment goals and risk preferences.
