Investment in ETF

 Investment in Exchange Traded Fund (ETF)

1.     What is an ETF?

“An ETF is a basket of securities, shares of which are sold on an exchange. They combine features and potential benefits similar to those of stocks, mutual funds, or bonds. Like individual stocks, ETF shares are traded throughout the day at prices that change based on supply and demand. Like mutual fund shares, ETF shares represent partial ownership of a portfolio that's assembled by professional managers.”

Source: What are the Different Types of ETFs and How Do They Work? (merrilledge.com) - https://www.merrilledge.com/article/getting-to-know-exchange-traded-funds

Buying and selling an ETF share is the same as buying or selling a stock. However, and ETF is less volatile than a stock, because its movement is depending on a basket of stocks (components) that it’s included.

2.     Types of ETFs

There are a number of types of ETFs, each with a different investment focus. Following are some of the most common ETFs.

Diversified passive equity ETFs are designed to mirror the performance of widely followed stock market benchmarks such as the S&P 500, the Dow Jones Industrial Average, and the MSCI Europe Australasia Far East (EAFE) indexes. Footnote 1 Major index-based ETFs have tended to follow their performance benchmarks closely.

Niche passive equity ETFs such as those that mirror the sector subsets of the S&P 500 or the small companies of the Russell 2000, may offer investors focused exposure to help them fine-tune their portfolio strategies. As with diversified passive funds, these niche portfolio funds are generally made up of the same stocks as those used to calculate their reference indexes.

Active equity ETFs allow their managers to use their own judgment in selecting investments, rather than rigidly pegging to a benchmark index. Active ETFs may offer the potential to outperform a market benchmark but may also carry greater risk and higher costs.

Fixed-income ETFs focus on bonds rather than stocks. Major fixed-income ETFs tend to be actively managed, but have relatively low turnover and generally stable portfolios.

Source: What are the Different Types of ETFs and How Do They Work? (merrilledge.com) - https://www.merrilledge.com/article/getting-to-know-exchange-traded-funds

3.     Net Asset Value [NAV] 

“The net asset value (NAV) represents the net value of an entity and is calculated as the total value of the entity’s assets minus the total value of its liabilities. Most commonly used in the context of a mutual fund or an exchange-traded fund (ETF), the NAV represents the per share/unit price of the fund on a specific date or time. NAV is the price at which the shares/units of the funds registered with the U.S. Securities and Exchange Commission (SEC) are traded (invested or redeemed).” 

·         Net asset value, or NAV, is equal to a fund's or company's total assets less its liabilities.

·         NAV, is commonly used as a per-share value calculated for a mutual fund, ETF, or closed-end fund.

·         For an investment fund, NAV is calculated at the end of each trading day based on the closing market prices of the portfolio's securities. For firms, NAV can be construed as close to its book value.

·         A firm's or fund's shares may trade in the market at levels that deviate from its NAV.

Source: Net Asset Value – NAV Definition (investopedia.com) - https://www.investopedia.com/terms/n/nav.asp

It is common that stock price * outstanding shares < NAV, so it is not a good deal to buy any stock that are traded under its NAV. Most of insurance companies have their stocks traded under its NAV.

It should be noted that NAV is calculated from estimation of holding assets. Their assets could be inflated from the market, thus NAV could be higher than it is actually worth.

For example, Toronto Residential Housing ETF estimates its holding assets as $10B based on value of its holding residential houses in Greater Toronto Area (GTA), so its NAV could be $10/share and assuming that its ETF is traded at $9.75/share. Is this a good deal? It depends on your view on the health of Toronto housing prices. If you think that Toronto houses were over priced and housing market would collapse or severely corrected down, then $9.75/share was not a good deal. This ETF should be considered as very risky and over priced.

4.     Share diluting or equity financing

In stock market, many companies have issued more shares or performed equity financing to fund their operations. This process dilutes the total number of shares outstanding, which are commonly unpleased existing shareholders.

Let’s take an example, Bell Canada has 1,000,000,000 (or 1B) shares outstanding, and their share price is $10 each. Thus the market capitalization of Bell Canada is $10 * 1B = $10B.

·         If Bell Canada needs $45M for expanding business, they may issue 5,000,000 (or 5M) new shares at $10 * 0.90 = $9 each, i.e. -10% lower than current market price to please new shareholders.

·         The market would likely dump or sell Bell Canada shares on the stock exchange to bring its share price down to $9 each, because they believed that Bell Canada share is worth $9 each as they offered to new shareholders.

·         The new market capitalization of Bell Canada is calculated as follows:

o   1B + 5M = 1,005,000,000 outstanding shares in total.

o   New market cap = 1,005,000,000 * $9 = $9,045,000,000 (or $9.045B) which is lowered than its original market cap of $10B.                                                  

o   Imagine if shares were traded at the same price $10 each after adding 5M more shares, its market cap would be $10,050,000,000 (or $10.05B) , and i.e. Bell Canada is more expensive with an additional value of $50M by adding only 5M shares.

It is common that existing shareholders will sell shares at an equity financing that makes share price down from the current price. As time goes, new shareholders will move in, if business is good, and share price will come back to higher level.

5.     ETF versus Mutual Fund

Mutual funds and exchange-traded funds (ETFs) have a lot in common. Both types of funds consist of a mix of many different assets and represent a common way for investors to diversify. There are key differences, though, in the way they are managed. ETFs can be traded like stocks, while mutual funds only can be purchased at the end of each trading day based on a calculated price. Mutual funds also are actively managed, meaning a fund manager makes decisions about how to allocate assets in the fund. ETFs, on the other hand, usually are passively managed and based more simply on a particular market index.

·         Mutual funds usually are actively managed to buy or sell assets within the fund in an attempt to beat the market and help investors profit.

·         ETFs are mostly passively managed, as they typically track a specific market index; they can be bought and sold like stocks.

·         Mutual funds tend to have higher fees and higher expense ratios than ETFs, reflecting, in part, the higher costs of being actively managed.

·         Mutual funds are either open-ended—trading is between investors and the fund and the number of shares available is limitless; or closed-end—the fund issues a set number of shares regardless of investor demand.

The three kinds of ETFs are exchange-traded open-end index mutual funds, unit investment trusts, and grantor trusts.

Source: Mutual Fund vs. ETF: Similarities and Differences (investopedia.com) - https://www.investopedia.com/articles/exchangetradedfunds/08/etf-mutual-fund-difference.asp

Each ETF is different with their basket of holding stocks, e.g. ABC Growth ETF is different than DEF Growth ETF even though both are invested in growth stocks. In order to find out the difference, we must find which stocks (components), that ETF bought, as well as its weight.

Most of ETF are holding a number of stocks (many different components), and each of them is carried a specific weight based on the total value of its ETF.

For example, ABC Growth ETF holds 10% of AAPL (Apple), 10% of MSFT (Microsoft), 5% of AMZN (Amazon), etc. Because each stock fluctuates everyday, the ABC Growth ETF must sell or buy each individual stock in the basket to ensure that the percentage of each stock stays the same or unchanged, e.g. 10% of Apple stock, 5% of Amazon, etc. This is a passive management, so its Management Expense ratio (MER), which is the management fee paying to the mutual fund or ETF manager, is lower than MER for active management of mutual fund. By the way, DEF growth ETF could hold 15% of AMZN, 20% of AAPL, no MSFT, etc.

ETF owners usually declare its components and its weight included in the ETF, so buyers could make decisions.

Mutual Fund managers don’t have any rules about weighting stock holdings or stocks to hold, i.e. they could buy any stocks as they see fit to their holding portfolio or fund objective (growth, dividend, balanced, fixed income, etc.). Mutual Fund managers are active money managers unless they offered index fund or ETF fund. Mutual Fund could change stock holdings every week, every quarter, or every year, i.e. it requires more time to do research and trade stocks. In contrast, ETF managers or owners only make sure that holding stocks are maintained at specified ratio or weight. ETF managers could also change its stocks holding or its corresponding weight occasionally, e.g. in several years as market changes. For example, if a component declared bankruptcy or poorly managed, ETF manager may replace it from the content with another stock.

6.     ETF money inflow

Unlike ETF, we need to send money to the mutual fund manager in exchange for the fund units, which are calculated by [Fund Value / Total Number of Units Issued] for unit price. Based on the money we deposit in the fund, we should get required units in our account. Mutual Fund manager would use our money to buy new stocks for the fund. By the end of each day, mutual fund manager recalculate fund unit price based on the formula mentioned earlier. Sometime they could issue new units in the fund, i.e. diluting the current unit holders. Try to research on the Internet to find out what happened when new units were issued.

“If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value [NAV] per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF: its shares trade at a discount from net asset value. 

When new shares of an ETF are created due to increased demand, this is referred to as ETF inflows. When ETF shares are converted into the component securities, this is referred to as ETF outflows.”

Source: Exchange-traded fund - Wikipedia - https://en.wikipedia.org/wiki/Exchange-traded_fund 

“When a mutual fund or ETF has higher net inflows, fund managers have more cash to invest, and demand for the underlying assets tends to rise. With increased outflows, the opposite is true. When investors are putting more money into funds, and inflows are higher, that tends to reflect greater overall investor optimism.”

Source: Fund Flow Definition (investopedia.com) - https://www.investopedia.com/terms/f/fund-flow.asp

Because ETF is traded like a stock on a stock exchange, we are buying or selling ETF shares with other ETF shareholders. If ETF owners issued in ETF shares, i.e. diluting current ETF shares outstanding, we may end up buying new ETF shares from the ETF owner. ETF owners could issue new ETF shares if demand higher than supply, i.e. ETF shareholders didn’t want to sell their shares, but many people wanted to buy. By issuing new shares, the ETF owners would have more money to buy additional stocks specified in the ETF, and make the ETF reasonably priced, i.e. not artificially inflated by people offering unreasonable high price for an ETF share.

7.     Is any ETF a safe investment?

As many people marketed out there, ETF or index funds are safe because it includes many stocks. However, you should pay attention to the including stocks [components], before making a decision of buying or selling an ETF.

S&P 500 index of USA holds 500 stocks in its index, thus it is kind of safe. However many people pouring money in this index has made it expensive or it’s traded at high PE. This could result in a market correction or S&P 500 index going down to a reasonable level.

An ETF could include some stocks in S&P 500 index, some stocks outsides of S&P 500, some foreign stocks, etc. There is no rule applied on ETF owners about stock holding. However, ETF owners usually declare its components and its weight included in the ETF, so buyers could make decisions.

For example, Electric Car ETF invests in electric vehicle industry. By looking at its disclosure, we found out that its weights are following: 70% in Tesla, 10% in GM, 10% in Ford, and 10% in Toyota. Based on our research on those stocks, we found out that

·         Tesla is trading at very high multiple (PE) and promising high future revenues, which could be missed in the future, i.e. share price of Tesla would likely to fall significantly in near term.

·         GM is at its all time (52-week) high, i.e. pull back or mild correction may occur

·         Ford is in the middle of reorganization, i.e. share price was unlikely moving up

·         Toyota is in normal operations, i.e. share price unlikely jumps up significantly.

With the above research, we would say that Electric Car ETF is not safe to invest in. Because if Tesla went down significantly, this ETF would deeply fall as a result. We don’t want to buy this ETF, because it is very risky.

We shouldn’t make assumption about stocks holding and its corresponding weights of an ETF. For example, Canadian Banks ETF doesn’t mean all Canada banks are included in this ETF at an equal weight or percentage.

8.     Summary 

In brief, investment in ETF is relatively safer than investing in a stock.

·         It is harder to get a basket of companies declaring bankruptcy than a corporation.

·         ETF fluctuates a little as compared to a stock.

·         It’s common to see a stock going up by 50% - 100%, but it’s not common for an ETF.

·         Your investment is diversified over a basket of stocks. 

However, it is also required to examine contents of ETF to ensure that its components and assigned weights were carefully selected, i.e. covering your areas of interests as well as reasonably priced.

--------

Author: Vinh Nguyen, B.Eng., LLQP

Email: canvinh@gmail.com