ETF Know Your Product (KYP)

Key questions

• Have reasonable steps been taken to understand the ETF to enable a suitability determination at both the individual holding and portfolio level?
• Have a reasonable range of alternative products been considered?
• What is the impact on the client’s account from the risk rating of the ETF?
• Have there been any recent significant changes to the ETF (e.g., risk level change)?
• Have you conducted your own due diligence of transferred in ETFs to determine their suitability?
• Have you documented your work supporting investment decisions?

Considerations

• ETF Due Diligence Checklist
• Largest and Most Liquid ETFs
• ETF Comparison Tool (results available in Excel and PDF)

Evaluating ETFs

The Canadian ETF market has expanded significantly. With hundreds of Canadian listed ETFs currently available, it has become increasingly important for investors to understand how to evaluate ETFs.

Choose Your Exposure
First, review the merits of diversification available through a wider exposure ETF against the precise targeting allowed by an industry ETF. For example, an investor looking to invest in Canadian banks could use broad market equity ETFs, dividend ETFs, financial sector ETFs, or a bank specific ETF.

Choose How to Access the Exposure
The majority of Canadian ETFs attain exposure by holding physical securities. A subset of ETFs use total return swaps to get market exposure. These ETFs receive the return of an index from a financial institution. An investor should analyze the added counterparty risk and additional fees against the advantages offered through the swap.

Choose How the Portfolio is Weighted
While ETFs may target the same market segment or industry, they could use a different weighting scheme such as market capitalization, equal weighting, or factor weighting. The appropriate choice may differ across asset classes or through the preferences of specific investors.

Choose a Trusted Provider
It is important to look at the track record, the product shelf, the ability to recognize investment trends, the capability to initiate industry development and the financial soundness of a provider. As the industry matures, ETF closures may occur, putting greater importance on using established providers.

Return considerations

Total cost
The total cost of transacting in an ETF includes the management expense ratio (MER), the trading expense ratio (TER), and the trading spread on the exchange. The MER will include management fees and taxes. The TER will include portfolio expenses such as commissions paid and withholding tax on foreign income. The trading spread will reflect the liquidity of the underlying portfolio and will decrease as the ETF matures and is more heavily traded in the secondary market.

A key consideration in evaluating total cost of ETFs against other investment vehicles is the time horizon of the investment. The longer the holding period, the greater the impact of the low MERs on ETFs. The shorter the holding period, the greater the impact of possible spread costs on ETFs.

Tracking error
A key measurement of success is the ETF’s ability to closely track its index. Tracking error can be both positive and negative. The expected tracking error may widen on more difficult to access asset classes compared to Canadian equities which are very liquid.