What are the different types of ETFs? And how do they work?

Stacey Steinberg
Vice President, ETF Strategist

 

Many investors know about exchange traded funds, or ETFs as they’re better known. However, some investors are unaware that there are actually three categories of ETFs, and they can deliver far more than simply mimicking an index’s performance:

If we think of this as a spectrum moving from left to right, as we move further to the right, the relevance of the index becomes less important, and costs increase. Considering where each one is on this spectrum can help you to make your investment decisions.

Let’s take a look at each of the three categories:

 

What are traditional index/beta ETFs?

Also sometimes known as passive ETFs, these funds track an index (and, of course, the rules that the index follows). They allow investors to gain access to nearly every conceivable investment space on the planet, from broad geographic exposure to sectors, subsectors and different asset classes.

The availability of these products has brought a degree of democratization to the investing public. A few decades ago, access to these spaces was available only to institutional money managers.

Index ETFs are low cost and offer daily transparency, providing investors with the ability to know exactly what they own, at any given time. Their value also lands on how they are used, which can range from pure building blocks of a portfolio to a more tactical use, such as for rebalancing.

For example, you could sell some loss-making assets for tax-loss harvesting purposes. Normally, you would have to wait 30 days to buy back into the same assets. However, if you don’t want to miss out on potential growth in those 30 days, you could buy an ETF that is highly correlated to that asset, but not identical. For example, you could sell a losing asset that follows a broad Canadian bond index and then buy an ETF that tracks a different broad bond index.

Index ETFs offer precise and transparent portfolio construction at a low cost. The bet here would be on the geography, sector or asset class of the ETF. One example of an index ETF is the Mackenzie US Large Cap Equity Index ETF (QUU), which tracks the popular large US companies space.  

 

What are strategic beta ETFs?

Also referred to as smart beta, these funds tweak the indices/benchmarks in order to improve performance compared to the index (known as delivering alpha). These tweaks could be across several factors, such as value, volatility, growth, geography and size. For example, there are times when small US companies deliver more alpha than large US companies.

Some strategic beta ETFs adjust the weight of underlying stocks or bonds in order to mitigate the risks of high concentrations of just one company or sector. Asset managers could take on lower positions of what they consider to be high-risk companies, for example, so the fund’s risk exposure would be much lower if the company’s price plummeted.

Given the additional resources needed to screen for factors and risk, etc., these ETFs are likely pricier than index/beta ETFs. Your bet here would be on the factors that are working now and in the near term, plus the cyclical element of these factors and risks. An example of a strategic beta ETF is the Mackenzie Maximum Diversification Emerging Markets Index ETF, which aims to increase diversification, reduce risk and enhance returns.

 

What are actively managed ETFs?

These ETFs follow a manager’s active strategies, and can be in fixed income, equity and balanced mandates, as well as in different geographical regions. These managers aim to beat their benchmark, rather than track it. Skillful managers do this consistently, even when taking into account fees, which are naturally higher, given that they provide their secret sauce.

With these ETFs, you’re mostly betting on the skill level of the active manager. An example of an actively managed ETF is the Mackenzie Unconstrained Bond ETF (MUB), which provides exposure to unconstrained fixed income.

 

When should you use traditional index/beta, strategic beta or active ETFs?

A good place to start is to ask yourself the following three questions when looking at your total portfolio and its parts:

  1. Is the space you are considering efficient? For example, many of the world’s analysts study US large cap equity very closely, looking for inefficiencies and information that isn’t yet priced into the market. As a result, this space tends to be efficient: it’s very hard to outperform a US large cap benchmark. Conversely, emerging market equity can be inefficient. For efficient spaces, it may make sense to simply invest in low-cost index ETFs.
  2. Are there active managers or strategic beta products that can consistently provide some value (above-average performance or better risk reduction) in the space that you are considering? Many active managers don’t outperform the index. SPIVA reports measure actively managed funds against their relevant index benchmark, so you can research funds before investing in them.
  3. Do you have the time and skill to seek out these successful products or managers?  Do you have the appetite to research all the due diligence considerations? Index ETFs can be a good option for investors who don’t have the time and/or skill to fully research products, while strategic beta and actively managed ETFs may be considered by investors with the necessary time and knowledge.

 

Learn more about the best ETFs for your portfolio

Choosing the right ETFs comes down to the risk and fees involved, plus the time you can devote to choosing them. You can read more about ETF basics in our blog, What are ETFs and why should I care?

And to find out more about the most suitable ETFs for your investment style and portfolio, talk to your advisor.

Commissions, management fees, brokerage fees and expenses all may be associated with Exchange Traded Funds. Please read the prospectus before investing. Exchange Traded Funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the prospectus before investing. The content of this article (including facts, views, opinions, recommendations, descriptions of or references to, products or securities) is not to be used or construed as investment advice, as an offer to sell or the solicitation of an offer to buy, or an endorsement, recommendation or sponsorship of any entity or security cited. Although we endeavour to ensure its accuracy and completeness, we assume no responsibility for any reliance upon it. This document may contain forward-looking information which reflect our or third party current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties and assumptions that could cause actual results to differ materially from those expressed herein. These risks, uncertainties and assumptions include, without limitation, general economic, political and market factors, interest and foreign exchange rates, the volatility of equity and capital markets, business competition, technological change, changes in government regulations, changes in tax laws, unexpected judicial or regulatory proceedings and catastrophic events. Please consider these and other factors carefully and not place undue reliance on forward-looking information. The forward-looking information contained herein is current only as of October 19, 2021. There should be no expectation that such information will in all circumstances be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise. This should not be construed to be legal or tax advice, as each client’s situation is different. Please consult your own legal and tax advisor.

Meet your authors

Stacey Steinberg
Vice President, ETF Strategist

Stacey has been working in ETFs since before most people had even heard of them. Two decades of experience at Barclays, BlackRock, Vanguard and Horizons has given her a passion for ETFs that she loves to share. A key focus for Stacey is to educate investors on all things ETF: their structure, how best to use them, their various strategies and their value.

“I like to help people fill the gap in their knowledge, so that they can make better-informed, and therefore more successful choices,” says Stacey. A background in both psychology and economics has also helped her to appreciate the emotional side of investing and better understand the needs of investors.