Today's exchange-traded funds are a far cry from the first generation of funds, whose fundamental purpose, when launched in 1990, was to passively track market indices such as the Toronto Stock Exchange.
ETFs have evolved to become a more diversified and sophisticated investment tool designed to appeal to a wider variety of investors.
"Depending on your desires, your objectives as an investor, there's just about something for everybody as it relates to the exchange-traded market now, which is exciting," says Michael Cooke, senior vice-president and head of exchange-traded funds at Mackenzie Financial Corp. in Toronto.
"Investors can generally find just about anything they're looking for in terms of strategies and objectives within the ETF market. There's a lot of innovation happening in the industry that's worth paying close attention to. It's a highly relevant product category. It gives investors more choice," he adds.
Fabio Campanella, a licensed investment advisor and principal with Praetorian Wealth Advisory in Oakville, Ont., also lauds the widespread appeal of ETFs, noting that they are a good way for individual investors to build a core portion of their portfolio with a variety of funds, such as dividend-paying Canadian, U.S. and international ETFs, as well as bond or fixed-income ETFs.
"ETFs can really fit into anybody's portfolio – from somebody who is just starting out in their 20s with $10,000 to invest, all the way up to a sophisticated older investor that needs to get in and out of a market very quickly," he says.
Mr. Campanella, who is also a partner with the accounting firm Campanella McDonald LLP, places ETFs into three broad categories. The first category includes traditional, low-cost, passive indexing ETFs, which he says are the most popular type.
The second category of ETF is more active, and will typically involve an investment manager who may decide to buy or sell as a means of executing certain investment strategies.
"Those types of ETFs are completely different from the passive ETFs. Their fees are usually much higher. And the strategies tend to be more complex," explains Mr. Campanella.
The third category is a sort of hybrid between the passive, indexed-based ETF and the more actively traded, professionally managed funds. These ETFs are rules-based and don't necessarily track an index per se.
"For example, they may pick a bucket of investments from the Toronto Stock Exchange or the S&P 500, but there's a set of criteria attached to the selection process such as rules stating that these must involve companies that have had increasing dividends over the recent past, or certain stipulations with respect to earnings ratios, free cash flow, and so on and so forth," says Mr. Campanella.
"These rules create the hybrid between active-managed and passive-indexed tracking ETFs. And their fees are basically somewhere in between the active and passive ETFs," he explains.
Mark Raes, head of ETF Business Development with BMO Global Asset Management in Toronto, says ETFs have evolved to the point where there are now approximately 500 products and 25 providers in the market in Canada.
"In today's market, ETFs really do equalize the playing field for investors, where you can see the biggest institutions right through to individual investors buying the exact same product. And that makes them fairly unique as an investment solution," says Mr. Raes.
"I think everyone typically starts their investment portfolio with broad equity and fixed-income exposures. ETFs do that, and do it very well, so they can form the core of a portfolio. But as well, there are more differentiated or focused ETFs that can appeal to different types of investors," he adds.
For example, low volatility ETFs or dividend ETFs can appeal to more defensive or conservative investors.
Mr. Raes cites his bank's BMO Low Volatility Canadian Equity ETF, , as an example. It is most heavily weighted in financial sector stocks (about 25 per cent) followed by the utilities and consumer staple sectors (roughly 14 per cent each), and then the real estate and consumer discretionary sectors of the Canadian economy (about 11 per cent each), comprising in total about 75 per cent of the portfolio.
ETFs are also a strong diversification strategy, says Mr. Campanella. For example, if an investor holds an ETF that tracks the S&P TSX 60, which includes 60 of the largest stocks on the TSX, even if that entire market has a large downfall, the possibility of the ETF dropping to zero is slim to none, he notes.
Other types of ETFs, like momentum ETFs, which have a higher exposure to market risk, such as single country ETFs, or emerging market ETFs, can appeal more to a higher-risk investor, Mr. Raes explains.
There are both structural advantages and differences associated with ETF investments, which investors need to take into account in determining what percentage of their investment portfolio should consist of ETFs, explains Mr. Cooke.
A key structural advantage is transparency. ETFs provide investors with live access to both a bid price and offer price for ETFs, and the underlying securities, at all times throughout the trading day. In comparison, "other investment vehicles don't necessarily afford you that insight. You're just transacting at an end-of-day price," he notes.
The ability to trade in real time allows investors to decide whether they are comfortable transacting at the current price, or whether they should continue to monitor the market and wait for the bid and offer prices to move to levels they think are more commensurate with the price they want to pay, Mr. Cooke says.
ETFs can also be beneficial for investors who are seeking to execute trades for tactical reasons, such as for asset allocation purposes, or because they have a positive view of a particular market or a segment of that market at a specific point in time.
However, the same intra-day liquidity that provides ETF investors with an advantage might also present limitations, because in order to take advantage of being able to buy and sell, the underlying investments must be liquid and investable.
Furthermore, in order to provide real-time quotes throughout the trading day, an investor needs to have ready access to current prices on all the underlying securities or asset classes that are held within the ETF.
"For example, private equity, or direct real estate would be examples of asset classes that just don't lend well to inclusion in an ETF structure where you need real-time pricing throughout the trading day," says Mr. Cooke. "So you're generally looking at more liquid segments of the different financial markets when you're building an exchange-traded fund," he adds.
But the bottom line is that more and more investors are deciding ETFs are right for their portfolio.
According to Strategic Insight of Toronto, which provides research, marketing and other services to the global asset management community, ETF assets accounted for 8.7 per cent of all investment fund assets in Canada, including ETFs and mutual funds, as of Aug. 31. There were $133.8-billion in ETF assets under management, out of a total of $1.546-trillion in combined ETF and mutual-fund assets under management.
"ETFs appeal across client types, because they are typically broad exposures, because they are diversified, because they are transparent. And because they're also low fee, there's not a type of client or type of portfolio that they don't work for," says Mr. Raes.