Myth #1: ETFs are just like stocks
ETFs trade on an exchange like a stock; however, unlike a stock, which has
a limited number of shares available for sale or purchase, an ETF is an
open-ended fund that can create new units based on demand. This means that
clients can buy larger blocks of units without worrying about running
through the order book, while clients who buy smaller blocks will benefit
through offsetting client orders. Market makers will continually offer new
shares and will create new units when needed.
Myth #2: Stocks and funds outperform ETFs
Active management has an important part to play in financial markets and
can deliver meaningful outperformance; the challenge for active managers is
to do so consistently over time. Active managers typically target improved
risk-adjusted returns by selecting high quality stocks. ETFs can outperform
when the entire market lifts off or when higher fees and adverse stock
selection impacts active managers.
Myth #3: ETFs aren’t liquid
ETF liquidity begins with the underlying portfolio. Where ETFs are based on
harder-to-trade strategies, they will then have less liquidity. An ETF adds
liquidity through exchange trading, where as an ETF matures, more buyers
and sellers meet on the exchange and the ETF develops more liquidity than
its underlying portfolio. This is particularly beneficial in narrower asset
classes and fixed income, two areas with liquidity challenges.
Myth #4: ETFs are riskier than stocks and funds
Warnings that ETFs will cause instability, particularly in less liquid
areas like bonds, is a consistent refrain. Instead, I would turn this on
its head. While in fixed income markets, reforms have impacted liquidity
and execution, ETFs add liquidity because they hold a diversified portfolio
and because most of the trading on mature ETFs does not touch the
underlying portfolio. As an example, on our
BMO High Yield Bond US Corporate Bond Hedged to CAD Index ETF (TSX:
ZHY), a harder-to-access asset class, only 17% of the exchange trades in 2016
resulted in underlying portfolio trades. This percentage would only be
lower on larger U.S.-listed ETFs.
Myth #5: ETFs cause market crashes
An important caveat to exchange trading is that just like a stock, an ETF
is subject to the integrity of the markets – in other words, if there is a
market event, or large moves in investor sentiment, we should expect ETFs
to move with the market. ETFs are priced based on their underlying
portfolios, not the other way around. The assumption that since ETFs
impacted market stability as they became prominent, then, doesn’t pass the
At the end of the day, ETFs are an important innovation in financial
markets, and allow more investors to access different asset classes, and to
have better trade execution on more diversified portfolios. Just like
anything else, understanding how they work is critical to having a good
Kevin Gopaul is Head of Quantitative Strategies and ETFs, CIO Canada, Head of BMO
Global Asset Management. He is also Chair of the Canadian ETF Association.
This article first appeared in the Fall 2017 issue of
Your Guide to ETF Investing, published by Brights Roberts Inc. Reprinted with permission.
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