ETFs are a relatively low-cost investment product. That is one of the keys to their popularity among investors.
As investors flocked to ETFs the range of ETF products and strategies available to investors has widened. In addition to extremely low-cost passive index ETFs there is now array of ETFs using active strategies to capture unique sectors or benefits for investors.
Actively managed strategies typically take more time, expertise, and resources than a passive strategy. Therefore, costs associated with actively managed strategies can be higher than a passive index based ETF.
A cost-benefit analysis can help investors choose which ETF to buy, but not all the costs of an ETF are as obvious as investors might like. There are some key terms and numbers to look out for and factor into your analysis.
Most of the costs of an ETF will be captured by the Management Expense Ratio (MER). It’s written as a percentage of the net asset value of the ETF and captures the management fee as well as taxes incurred on the fund annually, and operating expenses which can include custody fees, stock exchange fees, legal fees, audit costs, etc. and the cost of fund valuations. Applicable operating fees are described in detail in the ETFs prospectus.
The management fee is, simply put, the fee the ETF manager charges on the net asset value of the ETF.
One cost that won’t be included in the MER is the Trading Expense Ratio (TER). ETFs are comprised of securities that fund providers trade on exchanges. Those trades are subject to commissions, which adds a cost to the ETF. At Harvest ETFs, many of our income ETFs use a covered call strategy to maximize income yield. Writing call options to sell premiums on our ETF holdings also adds to the trading cost. The TER for an ETF can be found within the ETF facts and MRFP (Management Report on Fund Performance) documents accessible on an ETF’s webpage.
Investors should also know that in buying or selling an ETF, they will be incurring costs in the form of trading commissions paid to the broker or dealer they’re working will. Some trading platforms don’t charge trading commissions. They will also be paying tax on any income generated by the ETF, as well as capital gains tax if they sell their ETF holdings at a profit, if held in a non tax-sheltered investment account.
Another potential source of cost comes from Tracking Error. Tracking error occurs in passive and index ETFs when the holdings in the ETF don’t exactly match the components of the index. Actively managed ETFs generally don’t have tracking errors because they don’t work to an index. All passive ETFs experience some tracking error, but experienced portfolio managers will employ certain strategies keep tracking error as low as possible. When trading large, high-quality equities with lots of liquidity, minimizing tracking error can be simple. ETFs that trade in niche sectors and small stocks with less liquidity will generally struggle to keep their tracking error in check.
With a clearer picture of the costs involved in an ETF, investors can make that cost-benefit analysis. Of course, the other side to weigh is the benefit picture. Finding those benefits can take a little more digging but there are some useful questions to ask yourself when conducting that research.
What alternatives are there on the market?
Comparing similar products is a great way to find out if the cost of an ETF is competitive relative to its peers or to find out if you’ve discovered an ETF with a unique strategy.
Does the ETF provide income?
Monthly income yields are a great way to offset the monthly costs of ETF investing. If the ETF can offer income far in excess of the combined costs, while still offering exposure to growth trends, that could be a significant benefit to consider.
How does the ETF help a potential investor?
It might seem cool to buy an ETF that holds a portfolio of rare vintage wines, but does that exposure benefit you as an investor? Always ask yourself if a product’s benefits align with your goals.
Are there any tax benefits to this ETF?
ETFs are typically taxed as capital gains when they’re sold, meaning you’ll only be taxed on a portion of your profits, if any, and not at all if held in a registered account (RRSP, TFSA, RESP, RRIF). Some ETFs, like those that use covered call strategies, provide income that’s taxed as capital gains, generating more tax efficiency than conventional income ETFs.
With a clear understanding of an ETF’s costs and a well-researched understanding of an ETF’s benefits and objectives, an investor can gain the knowledge and the power to help make the right decision for their investment goals.
To find out how your clients can benefit from this strategy call 1.866.998.8298.
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Equity Income ETFs
Harvest Equity Income ETF portfolios are invested in companies that are well-established, with strong balance sheets and consistent earnings growth. Once we select the best suited for the portfolio, we generate steady income by collecting dividends and by selling call options on a portion of the portfolio. This strategy provides the ability to pay attractive monthly distributions for our investors.