Put ETFs to work for your clients

Put ETFs to work for your clients

Contents 2 What are ETFs? 4 Potential benefits of ETFs 5 Comparing ETFs and mutual funds 6 How ETFs work 11 ETFs and indexing

Exchange-traded funds (ETFs) are attracting ever-greater attention from investors. They continue to grow globally, with assets of more than $2.5 trillion. That trend translates to Canada, where they are becoming a low-cost investment vehicle of choice. Canadian-listed ETF assets have more than tripled since 2008. 1 But just how do you explain an ETF to your clients? This guide will help you understand how ETFs work and the potential ways you can use them in your clients portfolios. 1 Source: Global Simfund, Morningstar, Bloomberg and Vanguard as of December 31, 2013. 1

What are ETFs? ETFs are mutual funds that are listed, bought and sold on a regulated stock exchange, typically through a stockbroker or brokerage platform. ETFs offer the opportunity to invest in a portfolio of securities that provide the same diversification benefits of mutual funds with the added benefits of liquidity and trading flexibility of individual stocks. And ETFs, on average, cost less than mutual funds. Tracking an index ETFs that use an indexing approach are built so their value can be expected to move in line with the index they seek to track. For example, a 2% rise or fall in the index should result in approximately a 2% rise or fall for an ETF that tracks that index. 2 While most mutual funds in Canada are actively managed funds, which try to outperform the market, ETFs in Canada are primarily passively managed index investments. They seek to track the performance of a broad market or a specific portion of it. Most index-based ETFs invest in all or a representative sample of the securities of the indexes they seek to track. Index fund Diversified Low cost Low turnover ETF Individual stock Continuously priced Liquid 2 An ETF with a low tracking error will not generally outperform the applicable index, but rather will produce a return similar to the index minus fees and expenses. 2

How ETFs are traded Investors and their financial advisors must trade ETFs through a brokerage firm. Units can be bought and sold at the current market price whenever the stock exchange is open. Unit prices typically reflect the approximate value of the ETF s underlying shares at any given point in the day. Mutual funds, conversely, can be bought and sold directly through the fund company. Regardless of when you place an order, the purchase or sale takes place only once, at the end of the day, at the same price for all investors (See Figure 1). Figure 1 ETF buyer Investment advisor Marketplace Investment advisor ETF seller 3

Potential benefits of ETFs ETFs offer several potential benefits. Taken as a whole, these benefits tell a compelling story about why ETFs may belong in a portfolio. Any one of them may resonate with a given client. Low costs Annual management expense ratios of index-based ETFs can be less than those of many conventional index funds, and significantly less than those of actively managed funds. However, you need to consider the all-in cost of investing in ETFs to determine whether they are right for your clients. This is because ETFs have costs associated with trading in the stock market, such as brokerage commissions and bid-offer spreads. Diversification Index funds and index ETFs invest in all or a representative sample of the securities in an index and provide a diversified investment. This offers access to a wider range of investments than an individual investor may otherwise have. Keep in mind that diversification does not ensure a profit or protect against a loss in a declining market, and that it is not possible to invest directly in an index. While Vanguard ETFs are designed to be as diversified as the original indexes they seek to track and can provide greater diversification than an individual investor may achieve independently, any given ETF may not be a diversified investment. Of course, like stocks, ETFs are subject to the traditional risks and potential rewards of the markets. The value of ETF units will rise and fall as markets fluctuate, so an ETF can gain or lose value over short or long periods. Liquidity The ability of dealers to create and redeem ETF securities on a regular basis ensures an underlying depth of liquidity. Unlike mutual funds, ETFs can be traded at market prices throughout the trading day at a price quoted on a regulated stock exchange. Transparency With straightforward physical ETFs, the issuer provides daily information to the market, including the ETF basket, or a close representation of the ETF portfolio, making ETFs a transparent investment option. The difference between physical and more specialist synthetic ETFs is covered on pages 6 and 7. Potential for tax efficiency Taxes have the potential to take a bite out of investment returns, so tax-efficient funds may have a place in your clients portfolios. The low turnover of an indexing approach can minimize capital gains distributions, which can, in turn, improve long-term after-tax performance and tax efficiency. 3 Trading flexibility ETFs are traded on a stock exchange, so they can be bought and sold through an advisor or a brokerage account any time the exchange is open. Investors can use stock-trading techniques such as stop and limit orders and short-selling. And ETFs can be bought on margin. 3 Although index funds typically do make fewer trades, changes to the underlying index will require the index fund to buy or sell shares in accordance with changes to the index it seeks to track. 4

Comparing ETFs and mutual funds Investment fund managers either seek to track an index or to outperform an index using an active management strategy. The detailed comparison of investment-type characteristics below can help put ETFs in context. ETFs Index mutual funds Actively managed mutual funds Access Units bought and sold through a stockbroker or platform offering brokerage services Units bought and sold directly through the fund company or through an advisor Units bought and sold directly through the fund company or through an advisor Pricing Unit prices set by the market throughout the trading day Net asset values determined once per trading day, after financial markets close Net asset values determined once per trading day, after financial markets close Management expense ratios 4 0.80% 1.49% 2.30% Transaction costs Brokerage commissions and bid-ask spreads on each direct purchase and sale None for funds that don t have a sales charge when purchased or redeemed directly with the fund. (Some funds do have sales charges) None for funds that don t have a sales charge when purchased or redeemed directly with the fund. (Some funds do have sales charges) Dividend reinvestment Availability depends on the fund sponsor or your broker, who may charge for the service Generally available at no charge Generally available at no charge Client services Provided by the broker Provided by the fund sponsor or a broker Provided by the fund sponsor or a broker 4 Source: Vanguard calculations using management expense ratios compiled from annual and semiannual MRFPs and/or financial statements by Morningstar, Inc. Data as of December 31, 2013. Cost comparisons are for illustrative purposes only and are not meant to be all-inclusive. MER is expressed as an annual percentage of fund assets. It is composed of the base management fee plus certain operating expenses, such as administrative costs, plus applicable taxes. Different components contribute to the respective MER calculations for actively managed funds and index funds. Transaction costs associated with the issue, exchange, sale, and redemption of funds are not included. Trading, portfolio rebalancing and optional costs, and income taxes payable by any unit-holder, are also not included. There may be significant differences between the investments that are not discussed here. 5

How ETFs work Your clients may have several questions about ETFs, such as how they re traded and the costs involved, and even how an ETF comes into being. This section covers these topics and more. Creation and redemption ETFs generally don t experience cash flows into or out of the fund. That s because only certain institutional investors (brokerage houses, for example) are authorized to purchase or redeem units directly, and they do so almost exclusively using securities. When these institutional investors purchase units of an ETF, they give the ETF a specific quantity of securities. The securities in this basket are part of the index the ETF seeks to track. Similarly, when these institutions redeem their ETF units, the ETF generally provides them with securities, not cash (See Figure 2). During these in-kind transactions, the ETF incurs minimal transaction costs and does not realize capital gains. Some baskets, however, don t physically contain the securities that an index seeks to track. Innovation in the industry has led to the introduction of swapbased ETFs, where the basket may be unrelated to the index, and one or more counterparties agree to pay the index return to the ETF. Also known as synthetic ETFs, swap-based ETFs may make sense in certain instances, such as in gaining exposure to markets that are difficult to access. But it s essential to understand how the ETF is structured and its practices around collateral, transparency and liquidity. Figure 2 Basket of securities Hold units ETF sponsor One creation unit (e.g. 50,000 units of ETF) Dealer (Certain institutional investors, such as brokerage houses) Trade on Toronto Stock Exchange Individual investors ETF redemption works in reverse, with the dealer providing ETF units to the ETF sponsor in return for underlying securities. 6

Secondary-market trading Perhaps the most noticeable way ETFs differ from mutual funds is how they are bought and sold. Institutional investors can sell their ETF units to individual investors on the secondary market. These individual investors may then sell their ETFs to other investors for cash. Individual investors and their financial advisors must trade ETFs through a brokerage firm. ETFs can be bought and sold at the current market price whenever the stock exchange is open. Unit prices typically reflect the approximate value of the ETF s underlying securities at any given point in the day. These market trades, however, have no effect on the ETF itself; no cash flows into or out of the ETF that would require it to purchase or sell portfolio securities, pay brokerage commissions, or realize capital gains. As a result, the ETF is largely able to hold down its operating costs and limit the distribution of capital gains to unitholders (See Figure 3). Of course, individual investors are subject to any brokerage commissions and capital gains triggered by trades on their behalf. Keep in mind that the market price of ETFs may be more or less than the net asset value. Figure 3 Investor A Works with advisor to create an investment mix that s right for him or her. Works with advisor to create an investment mix that s right for him or her. Investor B Advisor A Broker A Stock exchange Broker B Advisor B Places buy order for ETF units on behalf of Investor A. Initiates transaction with stock exchange. Completes transaction with brokers. Unit ownership changes from Investor B to Investor A. Initiates transaction with stock exchange. Places sell order for ETF units on behalf of Investor B. 7

Trading options Because ETFs trade like stocks any time during regular exchange hours, you can execute specific strategies to help your clients achieve their investment objectives. Here are some ways that ETFs can offer greater flexibility than mutual funds: A market order is an order to buy or sell a security immediately, at the market price. Execution, not price, is the priority, so with a market order, the price you receive can be unpredictable. You may want to consider using stop and limit orders to help protect your clients from trading a security at a lower or higher price than they want to. A stop order is an order that triggers a market order to buy or sell a stock once it reaches a certain unit price, known as the stop price. Be aware that stop orders may be triggered by temporary market movements or may be executed at prices higher or lower than the stop price because of market orders placed ahead of them. A limit order is an order to buy or sell a security at a specified price or better. Limit orders may not be executed immediately. They may be executed only partially, or not at all, depending on the availability of buyers or sellers at the price you have specified. Buying on margin allows your client to borrow a percentage of an ETF s value from the broker in order to purchase the ETF. Be aware that if the value of the ETF drops substantially, your client may have to deposit more cash in the account or sell some of the ETF. Short-selling is an investment technique that involves essentially borrowing a security and then selling it with the intent to buy it back at a lower price. Short-sellers hope to make money when the market goes down. If a security you have sold short for a client rises in value, however, your client can lose money and there s no limit to how much he or she can lose. In some cases, you can short-sell ETF units to hedge the risk of your client s other investments. You can also shift assets out of and back into an ETF on a short-term basis to realize any capital losses and better manage your client s tax liability. Excess return and tracking error Excess return and tracking error can help you evaluate ETFs. But to use the measures effectively, you need to understand what they represent and how much weight to give them in your evaluations. Excess return shows how a product s perfor mance compares with that of its benchmark over a given period. Tracking error indicates the consistency of a product s excess return in the same period. 8

When selecting products for your clients portfolios, it s important to keep excess return and tracking error in context. If total return is your primary criterion, then excess return will likely be more important than tracking error in your evaluations. If performance consistency is more important to you, then tracking error may be more relevant. Liquidity and average daily volume Investors who place large orders may pause when they see an ETF with average daily volume that they perceive as small. They may wonder whether liquidity is sufficient to receive the best price at the trade size. More important than the liquidity of an ETF, however, is the liquidity of its underlying securities. Why? It s a function of the creation and redemption process. When demand exists for ETF units, for example, a dealer can provide the ETF sponsor with a basket of underlying securities to create the units. The liquidity of the underlying securities is paramount. ETFs trade on an exchange like stocks. Whereas a large trade in a single stock can affect the trading price, a large trade in an ETF can be achieved, when necessary, through the creation or redemption of ETF units. The creation and redemption mechanism relieves the pricing pressure of large trades. So average daily volume for an ETF is often meaningless. More important to how any ETF may trade is the average daily volume of its underlying securities. Costs As with any investment, operating costs vary among ETFs. Generally, ETFs cost less to operate than both index and actively managed mutual funds. Because ETF investors place transactions through brokerage firms, the ETFs do not incur the administrative costs that mutual funds incur for such things as correspondence, customer service and account recordkeeping. That can allow ETFs to keep management expense ratios low, which leaves more money to work for investors over the long term. Keep in mind, however, that ETFs do incur transaction costs. Your clients likely will pay brokerage commissions whenever you buy or sell ETF units for their portfolios. ETF market prices also reflect bid-ask spreads. This is the difference between what an investor sells a security for and the somewhat higher price at which the investor buys the same security. Like other investment costs, these expenses are borne by the individual investor and can affect investment returns. 9

A few cautionary words When market volatility climbs, trading securities can become challenging. To help your clients obtain best execution when buying or selling ETFs, you may want to consider the following: Be aware at the open and close. At the open, not all underlying securities in an ETF may have begun trading. In such situations, the market maker can t price the ETF with certainty, potentially causing wider bid-ask spreads. At the close, fewer firms may be making markets in the ETF and fewer securities may be listed for purchase and sale than throughout the trading day. Consider using a block desk. When you place large orders, a block desk can break your trade into smaller increments over time to manage the effects of a large trade. Or it can create or redeem units directly with the ETF sponsor so as not to affect prices on the secondary market. Your block desk can also review pricing depth before placing a trade. Remember the basics. Pay attention to earnings announcements and other news from companies that are large constituents of an ETF s benchmark and to news such as the release of economic indicators. ETFs can trade at larger premiums or discounts during market swings, which can be prompted by such news. 10

ETFs and indexing Most ETFs in Canada, including those managed by Vanguard Investments Canada Inc., are indexed investments. Most Canadian mutual funds, meanwhile, are actively managed. Managers of indexed investments seek to track not outperform a market index. Managers of active funds, on the other hand, seek to outperform the market. Why would your clients be satisfied with earning what the market earns, minus costs? Because while outperformance is possible over short periods, Vanguard research shows that long-term outperformance is rare. 5 Investing is a zero-sum game. All investors holdings represent the market. When one investor outperforms, another must under perform. Factor in the costs of running a fund and your odds of outperforming grow longer. The costs of indexed investments generally are lower than those of actively managed investments. In Canada, they re much lower. Vanguard ETFs enjoy the low portfolio turnover that typically comes with indexing. Because indexed investments seek to track a market index, they don t need to constantly buy and sell securities, so they can limit the distribution of capital gains to investors. Vanguard and indexing When you invest with Vanguard, you have more than 35 years of index investing experience behind you. The Vanguard Group, Inc. launched the first equity index mutual fund for individual investors in 1976 in the United States. Funds based on bond and international indices followed in 1986 and 1990. We ve since applied our index management expertise to exchange-traded funds. As we ve developed proprietary software and sophisticated techniques for portfolio construction, risk management and trading, we ve also grown in size, scale and experience. Investors benefit through tight, low-cost benchmark tracking. Of course, an index investment is only as good as the benchmark it seeks to track. We select only market-capitalization benchmarks, which objectively reflect broad markets or market segments and thus minimize investment costs. Many index providers use benchmark construction best practices that Vanguard has promoted for years an industry endorsement of our leadership. You can feel confident that your clients returns will be close to the market s returns, minus expenses, and that your clients will know where their money is invested. 5 The case for index-fund investing for Canadian investors, Christopher B. Philips et al., The Vanguard Group, May 2013. 11

Alternative indexing? Some investment managers employ alternatives to market-capitalization weighting. Managers screen securities based on certain financial measures in an attempt for greater performance. These managers typically identify measures that tilt toward investments in value stocks and small- and mid-cap stocks. In bonds, a popular alternative strategy has been to weight sovereign issues using a debt-to-gdp ratio, which in current market conditions results in an emerging markets bias. These alternative index strategies can carry higher management expenses than market-cap-weighted indexing investments (See Figure 4). If you re truly looking to capture the market s returns, you may want to consider low-cost index funds that encompass the entire market. Figure 4 Actively managed Index Difference Canadian equity funds average MER Canadian equity ETFs average MER Vanguard Canadian equity ETFs average management fee Canadian fixed income funds average MER Canadian fixed income ETFs average MER Vanguard Canadian fixed income ETFs average management fee 2.63% 1.30% 1.33% 1.14 0.78% 0.36% Not applicable 0.24% 1.54% 1.15% 0.39% 0.73% 0.39% 0.34% Not applicable 0.9% With respect to the average industry management expense ratios (MERs), this table reflects MERs compiled from annual and semiannual Management Reports of Fund Performance and/or financial statements, excluding the Vanguard ETFs. MERs vary from mutual fund/etf to mutual fund/etf and do not include brokerage commissions or other trading expenses. For the Vanguard ETFs, the table reflects management fees payable by the Vanguard ETFs to Vanguard Investments Canada Inc. as reported in their prospectus. Data as of December 31, 2013. Cost comparisons are for illustrative purposes only and are not meant to be all-inclusive. 12

As you consider ETFs for your clients portfolios, you can count on Vanguard s indexing expertise and our record of putting investors first.

Vanguard Investments Canada Inc. 155 Wellington Street West Suite 3720 Toronto, ON M5V 3H1 Connect with Vanguard vanguardcanada.ca 888-293-6728 Commissions, management fees and expenses all may be associated with the Vanguard ETFs. This offering is only made by prospectus. The prospectus contains important detailed information about the securities being offered. Copies of the prospectus are available at www.vanguardcanada.ca. Please read the prospectus before investing. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. The first date of publication by Vanguard Investments Canada Inc. is June 2014. References in this presentation to Vanguard refer to The Vanguard Group, Inc. or to The Vanguard Group, Inc. and its subsidiaries including Vanguard Investments Canada Inc. and are used for convenience only. Vanguard ETFs are managed by Vanguard Investments Canada Inc., an indirect wholly-owned subsidiary of The Vanguard Group, Inc. Vanguard ETFs are available across Canada. Vanguard ETFs will be issued, exchanged and redeemed at their NAV only through certain authorized broker-dealers in large, specified blocks of units or baskets of securities. ( Prescribed Unit ). All transactions of less than Prescribed Unit aggregations are traded on TSX with the assistance of a registered investment dealer. The number of Prescribed Units is determined by Vanguard Investments Canada Inc, from time to time for the purpose of subscription orders, exchanges, and redemptions or for other purposes. This communication is solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security, including any security of any exchange-traded fund. The information is neither investment and/or tax advice, nor is it tailored to the needs or circumstances of any individual investor. All investments, including those that seek to track indexes, are subject to risk, including the possible loss of principal. Exchangetraded funds are subject to risks similar to those of stocks. Investing in ETFs involves risk, including the risk of error in tracking the underlying index. The performance of an index is not an exact representation of any particular investment as you cannot invest directly in an index. Diversification does not ensure a profit or protect against a loss in a declining market. Investments that concentrate on a relatively narrow market sector face the risk of higher unit-price volatility. Prices of small- and midcap stocks often fluctuate more than those of large-company stocks. Investments in exchange-traded bond funds are subject to interest rate, credit, and inflation risk. Because high-yield bonds are considered speculative, investors should be prepared to assume a substantially greater level of credit risk than with other types of bonds. Foreign investing involves additional risks including currency fluctuations and political uncertainty. Investments in emerging markets are generally more risky than investments in developed countries. All figures are provided on a delayed and unaudited basis as of the date indicated in this material, may change at any time and are not intended to be relied upon in determining which ETFs to buy or sell or when to buy or sell ETFs. Vanguard Investments Canada Inc. does not guarantee the accuracy, completeness, timeliness or reliability of the information, figures, illustrations, graphs and charts or any results from their use. 2014 Vanguard Investments Canada Inc. All rights reserved. EBBCA 052014