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The ETF space continues to expand, with exchange-traded products surpassing the $2-trillion mark in January of this year, according to research by BlackRock Inc. In 2012 alone the exchange-traded products space grew by 27%.

This course is divided into four main sections. Section One deals with strategies for investing with ETFs, covering three main topics: currency hedging, embedded strategy ETFs (ESETFs), and volatility ETFs.

Section Two looks at whether ETFs are to blame, as some charge, for higher equity correlations.

Section Three examines key tax-related issues that arise when investing in ETFs.

Section Four discusses how to choose the right ETFs for clients.

Section 1: Strategies for investing with ETFs

Currency hedging

ETFs began as plain-vanilla investments, but exotic variations have emerged.

One of them is currency-hedged ETFs, which index foreign stock or bond markets to create protection against currency fluctuations. This hedge proves favourable when the Canadian dollar is strengthening against the referenced currency, says John Gabriel, an ETF strategist at Morningstar.

If there are shocks to the system stemming from Europe, China, or elsewhere, the U.S. dollar will rally. In this situation, it makes sense for a Canadian investor to favour USD-denominated funds.

While predicting exchange rates can be a losing proposition, currency-hedged ETFs could make sense if an investor, with primarily U.S.-dollar-denominated investments, plans to retire in Canada, and will pay his bills in Canadian dollars.

The other benefit of using ETFs is cost: they generally have lower fees than their currency-hedged mutual fund equivalents.

Investors planning to retire stateside could avoid currency hedging by holding USD-denominated ETFs.

Running some numbers, assuming a U.S.-dollar denominated stock, shows how a small currency fluctuation can dent overall returns.

Let’s say the Canadian dollar is at parity with USD and S&P 500 is at 1,000. A year later, the benchmark goes up 10% to 1100, and one USD is now worth CAD1.05, up 5%. As far as a Canadian investor is considered, if the unhedged investment is sold after a year, the gains will be 15%: 10% equity plus 5% currency.

On the other hand, if a year later the USD weakens to CAD 0.97, a drop of 3%, and the equity gain remains 10%, the investor only gets a 7% return: 10% gain on equity minus 3% on currency.

Currency-hedged ETFs are not recommended when investing in emerging markets, says Vikash Jain, vice-president and portfolio manager with archerETF Portfolio Management.

“One of the hallmarks of emerging markets is their currencies are generally undervalued; this is one thing that gives them their competitive advantages,” he says. “As these countries develop, their currencies will strengthen. If you’re a long-term investor, you’d not want to buy a currency-hedged ETF for emerging markets.”

There’s another reason for going unhedged in emerging markets. For the broad indices like the MSCI EM Index, there’s no effective way to hedge all the underlying currencies. Even the hedged ETFs only hedge against the USD, says Jain.

Hedging adds risk

What’s more, the mechanism behind these ETFs can introduce risk to a portfolio. Hedges tend to be imperfect, which leads to tracking error, says Gabriel.

“Most providers use monthly futures to hedge, but if the fund experiences any meaningful inflows or outflows in the middle of the month, then the hedge is no longer 1:1,” he says. “Therefore, there will be tracking error until the ETF manager resets the currency hedge at the next monthly interval.”

The amount of protection—derived from OTC currency-forward contracts—depends on the value of the underlying index. This means the hedging ratio can suffer a large tracking error in volatile markets, says Guy Lalonde, portfolio manager at National Bank Financial.

Rebalancing the hedge more often may limit this, but will also introduce higher management costs.

Those looking to buy currency-hedged ETFs should assume they’ll end up paying fees or experience tracking error of about 1% above the MER.

It’s a trade-off. Investors need to weigh the potential benefit of asset-to-liability matching in the planning process against the additional costs associated with running a hedging strategy.

“I wouldn’t recommend that investors try to time their hedges [and] move back and forth based on how they think exchange rates will fluctuate,” says Gabriel. “Such speculative behavior can be very detrimental to the value of a portfolio.”

Embedded strategy ETFs

The number of embedded-strategy ETFs (ESETFs) has grown significantly in recent years as the traditional passive ETF product space became saturated.

Passive ETFs follow capitalization-weighted indices (except those based on the Dow Jones index, which are price-weighted), hold physical assets and offer proven, low-cost exposure to various asset classes. Risks accompanying passive ETFs are familiar to most investors—ESETFs bring new promises and a new set of challenges.

Unlike passive ETFs, ESETFs encompass a broad range of strategies that could be classified by investment strategy (other than a capitalization-weighted index) and by aspects of implementation (use of derivatives). The table “Types of embedded-strategy ETFs” shows some examples.

Types of embedded-strategy ETFs

Investment Strategy	Examples
Active investing	HAG, CMF, WXM
Fundamental indexing	CIE, PXC
Equal-weighted indexing	ZUT, CEW, HEW
Overlay strategies such as covered calls	ZWB, HEX, MXF
Leveraged investing	HXU, HXD

Implementation Aspects	Examples
Futures-based	ZCE, CBR
Forward- or swap-based	HXT, CAB

Risks arising from embedded strategies come in many forms. Often these risks are unfamiliar to mainstream investors. In Q4 2008, investors overlooked the volatility sensitivity of leveraged ETFs, mistaking the daily rebalancing target for a long-term performance promise. Expectations were shattered when unprecedented volatility punished both bull and bear ETF performance levels. Therefore, in order to use them successfully in portfolios, advisors must understand the risks inherent to ESETFs.

Active risk

For investors looking to build portfolios with stable risk profiles, active risk adds variables such as manager discretion, lower transparency (particularly in Canada) and higher tracking error. All of these factors contribute to additional uncertainty and obstruct the portfolio risk-management process.

Liquidity risk

ESETFs tend to have lower trading volumes, with the notable exception of leveraged ETFs (which are used primarily by active traders and constitute approximately two-thirds of the overall ETF trading volume in Canada). Lower liquidity for the remaining embedded-strategy universe means bid-ask spreads can be fairly wide. Market makers providing a liquid market for those ETFs have to hedge their positions. The lack of liquid hedging instruments results in basis risk that market makers pass on to investors with wider bid-ask spreads.

Volatility drag risk

Volatility risk takes on a whole new meaning with leveraged ETFs. Investors understand higher volatility generally means higher loss potential. For leveraged ETFs, the negative impact of volatility is more deterministic—in turbulent markets the performance of a daily rebalanced leveraged ETF suffers due to volatility drag. Mathematically, this is expressed as the difference between the arithmetic, or daily rebalanced, return and the geometric, or end-of-period, return. The latter is relevant to the investor as it represents money in the account at the end of the investing time horizon.

Transparency issues

ETFs are famous for their transparency, compared with other managed-money products. This is particularly true of passive ETFs. In Canada, however, many embedded-strategy ETFs take advantage of the less stringent regulatory environment. Compared with the U.S., where ETF manufacturers are required to disclose complete holdings daily, in Canada, manufacturers need only disclose their top 25 holdings quarterly and full holdings annually. Manufacturers argue less transparency benefits investors by helping to protect against front-running. The downside is that any investor who actually manages portfolio risk would find it hard to make accurate estimates when the holdings are unknown.

Credit risk

Some ETFs use over-the-counter derivatives such as forwards and swaps to gain exposure to the underlying securities (e.g. Horizons BetaPro COMEX® Copper Bear Plus ETF (HKD)) or to create a tax-advantaged structure (e.g. iShares Global Monthly Advantaged Dividend ETF (CYH)). These derivatives are subject to counterparty credit risk and can influence the market value of the ETF assets if the credit quality of the forward or swap issuer deteriorates significantly.

Roll risk

Commodity ETFs, unless they invest in the physical asset, such as the iShares Gold Trust (IGT), are subject to roll risk. Roll risk occurs when the spot price of an asset differs from the futures price resulting in contango or backwardation. Some commodity products, such as PowerShares DB Gold Double Long ETN (DGU), attempt to optimize roll yield.

Investing with ESETFs can provide new portfolio construction opportunities and give access to an array of diversifying asset classes. They also come with new risks of which investors should be aware. From the daily challenge of assessing active risk and liquidity costs, to the dormant credit risk and volatility drag, investors need to look at the additional sources of uncertainty when investing with embedded-strategy ETFs.

Volatility ETFs

Volatility ETFs are funds that allow you to trade or invest in volatility as if it were an asset class. They do so by purchasing (long exposure) or selling (short exposure) futures contracts on volatility, since spot (cash volatility) isn’t readily accessible.

This can be difficult, since volatility isn’t predictable, except when it’s at extreme levels (below 15%, or above 35% to 40%). In those cases, it’s likely that volatility will change direction.

VIX recently dropped to five-year lows—even though remaining economic concerns justify higher levels.

Let’s look at a brief history of VIX ETFs, their appeal today and the challenges they present for buyers.

VIX measures the implied level of volatility embedded within the price of S&P500 options trading on the Chicago Board Options Exchange (CBOE) for the next 30 days. In other words, it’s the portion of the price that reflects anticipated up or down movements over that timeframe.

High VIX levels mean people expect a high degree of price variability, while low levels mean people expect less. As such, VIX is often referred to as a fear gauge.

Why VIX ETFs?

Correlations (similar directional price moves of corresponding proportions) have risen on several occasions since 2008. This left many investors looking for alternative investments (with lower or negative correlations) that provide shelter during periods of overall price decline. Volatility tends to rise sharply during such episodes —with prices concurrently dropping—so these instruments work for risk diversification.

VIX exposure is a potential hedge against long positions. Exposure to this volatile index can provide significant gains, as a result of the price movement it experiences over time.

One Example

In the U.S., Barclays iPath launched VXX and VXZ in January 2009. The latest Assets Under Management are US$2.02 billion for VXX; US$201.3 million for VXZ (at August 28, 2012). The key difference between these two Exchange Traded Notes (ETNs expose their buyers to credit/counterparty risk, whereas ETFs don’t) is in the underlying futures contracts being purchased and rolled over (as they reach expiration) over time.

VXX provides exposure to S&P500 VIX Short Term Futures Contracts, while VXZ seeks to track S&P500 Mid-Term Futures Contracts, since investors can’t buy VIX on a spot basis. Further, exposure to it via futures contracts can prove costly over time because you must roll the contracts over monthly. This is because of contango, a situation where futures contracts trade at a premium that gradually disappears as it reaches maturity. As the futures curve flattens (contango is greater at the front end of the curve), VXZ seeks to minimize contract rolls by investing further out on the curve.

VXX is at risk of greater value erosion (because it rolls contracts over more frequently) than VXZ (which invests in futures contracts further out on the curve, where it’s flatter). The overall trade-off is that VXX provides better traction to spot price movements in volatility (50% to 60% participation over time), compared to VXZ (30% to 40% over time).

When To Use VIX

Volatility ETFs do not allow 100% upside participation in VIX because of the use of futures contracts, and the cost of rolling over these contracts through time. Also, leakage in the investment value can occur if you don’t deploy the ETF when VIX is rising. But there is significant short-term upside potential when volatility levels spike.

Canadian ETFs

There are three ETFs from Horizons that provide exposure to VIX.

• HUV – HBP S&P500 VIX Short Term Futures ETF
• HVU – HBP S&P500 VIX Short Term Futures Bull Plus (2X leverage daily reset) ETF
• HIV – HBP S&P500 VIX Short Term Futures Inverse ETF

Horizons launched HUV and HVU, which provide long volatility exposure, in December 2010. HIV, which rises when volatility declines, was launched April 2011. The latter benefits from value leakage over time.

Overall, these fast-trading vehicles aren’t for the buy-and-hold crowd, and haven’t garnered the levels of assets of their U.S. counterparts ($56.5 million AUM for all three at August 29, 2012), since some investors aren’t familiar with volatility as an investment tool. Also, it’s challenging to make money with this type of ETF, given that exposure is secured.

HVU provides the highest potential, but is also the riskiest because its use of leverage is reset daily. Interestingly, it’s the one investors seem to favour, much as VXX is favoured in the U.S. This focus on near-term volatility speaks to people’s desire to capture spot VIX moves, as opposed to mitigate minor losses—and confirms the speculative nature of VIX investments. (See chart below.)

Weekly % price change Bull+ VIX S&P500 Short term

Section 2: ETFs and market dynamics

ETF trading to blame for rising U.S. equities correlation?

A study by James Xiong, senior research consultant of Chicago-based Ibbotson Associates and Rodney Sullivan, CFA, titled, “How Index Trading Increases Market Vulnerability,” contends correlation among U.S. equities has been rising primarily as a result of heavy ETF and index fund trading. (Their findings do not pertain to other asset classes.)

The study says U.S. equities correlation has increased in the past 10-to-15 years—the same period index funds were introduced into the market—because frequent buying and selling cause fund constituents to move together like schools of fish. That raises correlation.

As a consequence, an investor who buys an index fund such as the S&P500 would have a significantly lower magnitude of diversification compared to what she would have had 10-to-15 years ago.

Sullivan and Xiong compared equities in the S&P500 and found correlation among large caps was approximately 10% to 15% between 1983 and 2000. After 2000, the correlation rapidly rose to its current level of approximately 50%. What’s more, “To date, correlation of small-cap stocks has also risen to stand at around 50%.”

What these findings suggest, says Sullivan, is that diversification benefits are far less than what they used to be. Within an equity portfolio, it now takes about twice as many stocks to be fully diversified.

ETFs and index funds are an easy target

There’s no disputing correlation among equities, particularly risky assets, has been rising over the past 15 years, says Christopher Philips, senior analyst at Vanguard Investment Strategy Group. But to pin the blame on ETFs or index funds is unfair because they represent only 10% of the overall U.S. market.

The more likely factors driving up U.S. equities correlation are globalization and availability of market information. Also, ETFs and index funds are price takers, says Phillips, and as such they do not drive stock prices—active managers do.

Correlation is not the end-all in portfolio diversification

Phillips also takes issue with Sullivan’s and Xiong’s primary focus on correlation. He says this measure is not the only determinant of portfolio diversification.

A high correlation between two stocks doesn’t necessarily mean they’ll move in lock step. Inclusion of other measures in portfolio diversification such as dispersion, volatility and return differentials would provide a fuller analysis of the stocks’ performances.

Phillips compared the correlation of Exxon Mobil and Chevron. Despite their high daily correlation of 0.85 during the last three years, Chevron outperformed Exxon by 30 percentage points: a 110% cumulative return versus a 146% cumulative return.

Sullivan clarifies ETFs provide cost-efficient diversification, but frequent trading disrupts correlation patterns. So, his report argues for even broader diversification.

Section 3: Tax implications of ETFs

While the structure of an ETF often makes taxes less concerning vis-à-vis a comparable mutual fund, ETFs can still trigger capital gains.

So Michael Nairne, CFP, CFA of Tacita Capital in Toronto, advises looking carefully at a fund’s underlying index composition to minimize taxes for clients.

“An ETF focussed on a narrow band of securities that sees a great deal of turnover will frequently generate gains. This can lead to a year-end capital gains distribution,” he says. Conversely, a broad index has lower turnover and, therefore, lower risk of distributions.

ETFs that employ covered calls trigger a stream of capital gains that are distributed by the fund. When a mutual fund makes a taxable distribution, there is corresponding reduction in Net Asset Value per Share (NAVPS). Hence, whether the distribution is by way of cash or reinvestment of additional units, it’s easy to track the Adjusted Cost Base (ACB) of the investment.

ETFs sometimes make taxable year-end notional distributions, which are neither cash distributions nor reflected in the reinvestment of additional units. So, unitholders don’t see change in the number of units they hold, and the underlying NAVPS doesn’t change either.

These notional distributions are reported by the custodial firm or dealer, but the ACB could be under-reported unless the custodial firm or dealer adds the notional distribution to the investment’s ACB.

“An advisor needs to check,” adds Nairne. “[The ACB calculation] isn’t always automatically adjusted. If an investor holds the funds over several years the ACB might have to be adjusted several times.”

The brokerage firm is responsible for providing all tax reporting on ETFs. That’s unlike mutual funds, where the fund company provides a lot of services. Investors receive a T3 directly if a capital gains (or other) distribution occurs.

Composition matters

If an underlying stock is purchased in a merger, the index composition needs to be rebalanced to ensure the ETF continues to replicate the index. This can lead to significant underlying stock redemptions, triggering a series of capital gains that must be distributed to the fund.

Graham Westmacott, a portfolio manager at PWL Capital, emphasizes the need to closely examine the underlying assets to determine if they truly represent the index. If the index is tracking through derivatives, there is often a counter-party risk associated with the derivative, and the ETF may suffer losses if the counterparty defaults.

“Some providers act as their own counter party; and whether they are taking profit from the derivative trade or the ETF will impact the investors,” he says.

Bond ETFs typically pay out interest as a monthly dividend, which is taxed as regular income. As a result, they should be held in registered accounts. Any capital gains are paid out as an annual distribution.

But these ETFs don’t offer automatic diversification; some could be heavily weighted to one or two companies. “You need to pay attention to how much debt you are exposed to from one particular company in the investment basket,” says Westmacott. “Are you safe investing in a fund that carries a great deal of debt from one bond provider?”

Real-estate ETFs can offset the taxable portion of distributions with capital cost allowances from depreciation of the properties in the underlying REITs. Westmacott says that gives real-estate ETFs an extra degree of freedom.

“If the REIT basket experiences a return of capital from property depreciation,” he says, “it is able to net it off to reduce the resulting taxable distribution.”

Capital gains realizations can be triggered by corporate actions in an underlying stock. If an ETF tracks a large-cap index and an underlying stock no longer meets that definition, the stock would have to be sold. The market maker would take the primary capital gains hit, but it could be passed on to ETF investors in the form of a fully taxable cash distribution.

U.S.-based ETFs

While U.S. ETFs traded on Canadian exchanges are subject to our tax rules, it’s possible for a Canadian to own U.S. ETFs traded on the NYSE without using a holding company.

Nairne says advisors must scrutinize the set-up of the ETF, because some are not typical trusts but rather structured as notes or grantor trusts, and the tax treatment can be different. While the fees are lower, foreign dividends from such ETFs do not qualify for the dividend tax credit afforded to Canadian companies.

Also, the IRS considers ETFs or stocks held on an American exchange to be U.S. assets for U.S. estate tax purposes. These investments can result in a large, unanticipated estate tax exposure if an individual owns assets in the U.S. in excess of the exemption limit.

Since most capital gains distributions are done at year-end, investors can avoid distributions by divesting before December 31, or waiting to buy until January. Westmacott says people focus on ETFs’ short-term tax implications, when in reality product quality is more important for long-term investors.

Section 4: Choose the right ETFs for clients

Finding the right ETFs for your clients is becoming increasingly challenging.

In the last three years, the number of funds has quadrupled from 60 to more than 250; leaving many lost in a maze of new, specialized products with varying structures and fee models.

Should you be researching every product that comes to market? Both advisors and providers say no, and the science backs them up.

Don’t overwhelm clients

Over the last few years, neurofinance has taught us people can only handle a few choices at any one time.

So, find out which types of funds are most appropriate, based on clients’ time horizons and risk tolerances. If they’ve asked for ETFs, ask their views on why the product will improve their portfolios. Then, suggest three-to-five funds based on those preferences and needs.

Greg Stevenson, wealth advisor at Richardson GMP in Calgary, uses Standard and Poor’s quarterly SPIVA report to discuss the recent performances of managers and indices. He explains tracking error and ETFs’ fee structure, and outlines the indexing structure used by each fund his clients choose.

How to choose funds

High-quality ETFs stick close to their mandates, neither outperforming nor underperforming underlying indices.

They should also provide value and stability over the long-term, says Justin Bender, associate portfolio manager at PWL in Toronto. He sticks to broadly diversified, tax-efficient funds that follow major indices and, rather than focusing on its independent performance data, considers how each will act within a client’s portfolio.

Cutting-edge funds offering double volatility and leverage may seem exciting, for instance, but aren’t designed for the majority of investors.

“Adopting a one-size-fits-all approach is dangerous,” says Mary Anne Wiley, managing director and head of iShares, Blackrock Canada. She says an increasing number of products are being released to meet demands in niche categories, such as strategy-based funds that identify promising stocks in given indices rather than merely tracking them.

If a client comes in excited about a risky or narrowly segmented fund that’s likely too complex or unsuitable, steer them away.

You should also suggest ETFs that have better performance history and higher return potential. Some advisors first choose a good provider and then look for funds; others start by choosing a suitable sector and then scan every provider’s offerings.

Some of the new indices are so niche that no basis exists for performance comparison. So caution is merited. Atul Tiwari, managing director of Vanguard Canada, says it’s crucial for investors to understand the index being tracked and the methodology behind each product before taking the plunge.

Stevenson says specialized ETFs are only suitable for experienced investors who are aware of their risks and complexities. Bender’s portfolios use only four funds, along with four back-up ETFs in case tax-loss selling opportunities occur. He also uses low-cost mutual funds to provide fixed-income and global real-estate access.

Sample ETF portfolio

Asset Class	Current ETFs	Temporary Replacement ETFs (for tax-loss selling purposes)
Canadian REITs	iShares S&P/TSX Capped REIT Index Fund (XRE)	BMO Equal Weight REIT Index Fund (ZRE)
Canadian Equities	iShares S&P/TSX Capped Composite Index Fund (XIC)	Vanguard MSCI Canada Index ETF (VCE)
U.S. Equities	Vanguard Total Stock Market ETF (VTI)	iShares Russell 1000 Index Fund (IWB)
International and Emerging Markets	Vanguard Total International Stock ETF (VXUS)	Vanguard FTSE All-World ex-U.S. ETF (VEU)
Equities

This course is based partly on articles written by Ioulia Tretiakova, vice president and director of Quantitative Strategies at PÜR Investing, and Yves Rebetez, CFA, managing director of ETFInsight.

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