Exchange Traded Funds: Everything You Wanted to Know But Were Afraid to Ask

Posted on: May 22, 2019

By Karin Mizgala, Co-Founder and CEO Money Coaches Canada

Most Canadians are very familiar with mutual funds. In simple terms, a mutual fund is made up of a collection of individual stocks, bonds or other securities carefully chosen by a fund manager, with the goal of generating returns for the investors while balancing risk. Investors pay a management fee, referred to as the Management Expense Ratio (MER), to cover the cost of the management, marketing and administration of these funds. In Canada the average MER is around 2%.

With greater focus on the cost of investing and fee transparency in Canada, it’s not surprising that there is growing interest in Exchange Traded Funds (ETFs), which in most cases, have lower fees than mutual funds. But what else should you know about this up-trending investment option before deciding if ETFs are right for you?

An ETF Primer

An ETF holds investments that track an index, commodity, bonds or a grouping of assets. Unlike a mutual fund that is actively managed and strives for higher returns for its investors, an ETF seeks to match the benchmark return of the index it tracks.

Each ETF trades like a stock on the exchange. Each has its own ticker symbol and its value changes throughout the day. It can also be bought and sold at any time during trading hours. This is very different from a mutual fund that can only be purchased or sold at the end of a trading day. And its value is determined only at market close.

You might also be interested in knowing that the creation of the ETF has a Canadian connection. Although the first attempt at creating an ETF was in Chicago in 1989, which proved unsuccessfully due to the actions of a federal judge, the next attempt, which proved successful, occurred on the Toronto Stock Exchange in 1990. The Toronto 35 Index Participation Units (TIPs 35) tracked the TSE-35 Index. This innovative, less costly entrant to Canadian equities was very successful and spurred the creation of more EFTs in Canada. In 1993, the US modeled the Canadian success with the creation of the SPDR S&P 500 Trust ETF which is still one of the most popular ETFs in the world.

The Growing Popularity of ETFs Among Canadian Investors

2018 was a very successful year for the Canadian ETF industry. The industry attracted $20 billion in net inflows and saw the introduction of 140 new ETF products. Today, there are over 30 Canadian ETF providers – including all the nation’s big banks.

On the heels of a strong 2018, a new report from BMO Global Asset Management (BMO GAM) predicts that ETF asset growth is set to continue – more than doubling over the next five years. With such growing popularity, it would seem that ETFs are at least worth a look. But as with all things in life, there are pros and cons, and no investment is suited for everybody.

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What Are the Advantages of an ETF?

1. Lower Fees

An ETF aims to be on track, but not surpass, the return of the index it follows. This passive management style makes it a less expensive option than a mutual fund which employs a fund manager actively working to achieve a higher rate of return. The cost of purchasing or selling ETF shares through a discount brokerage account is in the 0.05 to .5% range, compared to 2% or more per year on a mutual fund.

Yes, lower fees are a key advantage of investing in ETFs. However, the extent of the advantage is affected by the way you invest. For example, if you purchase your investment through a Robo-advisor, fees for ETF portfolios are typically in the .5 to .8% range. If you purchase an ETF through an investment advisor, your ETF portfolio could cost you 1% or more.

2. Returns

Many studies show that 70-80% of actively managed mutual funds aren’t outperforming the index which is another reason for the rise in popularity of ETFs.

3. Diversification

Investing in a range of assets is less risky than a single stock or bond. Investing in several ETFs can increase the diversification of your holdings even more. In addition, you can adjust your allocation in multiple ETFs to match your risk tolerance and financial goals.

With an ETF, there are no minimum investment requirements, and you can purchase as little as one share. And fear not if, as an investor, you love receiving a dividend check from your investments each month. Dividends are collected from the companies within the fund by the ETF fund manager and passed on to you.

So, what’s the downside?

As mentioned above, to benefit from the full cost advantage of ETFs, you need to be a do-it-yourself (DIY) investor. You will incur additional expense purchasing ETFs through an advisor, reducing one of the primary advantages of this type of investment. As a DIY investor, you need to be comfortable with your ability to research, select and manage your investment portfolio.

When shares in an ETF are bought and sold in low volumes, the fund is referred to as thinly-traded. This can lead to a wide bid-ask spread (the difference between the highest price that a buyer is willing to pay for a share and the lowest price that a seller will accept to sell it), and lower liquidity. Or put another way, you may be forced to pay a little bit more when buying, or receive a little bit less when selling, for an ETF that is not actively traded day-to-day.

Before investing it’s also important to investigate the ETF’s tracking error. The goal of an ETF is to target, or track, a specific market index. The success to which it does or doesn’t hit its target is the tracking error. If a fund is closely following its benchmark, it will have a low tracking error. A high tracking error, will lead to a more volatile portfolio.

Types of ETFs

As the popularity of these funds increases, new types of ETFs are being created around different markets. Here is just a sampling of the different types of ETFs available:

  • Index: Designed to track a particular index, like the S&P 500 or NASDAQ
  • Commodity: Designed to track the price of a commodity, such as gold, natural gas or coffee
  • Inverse: Designed to profit from a decline in the underlying mark or index
  • Industry: Designed to provide exposure to a particular industry, such as high tech, defense or agriculture
  • Style: Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth
  • Bond: Designed to provide exposure to bonds of essentially every type available

ETFs Still Require Some Research and Decision Making

There is a lot to think about when considering an ETF; like any investment it has to meet your personal financial needs.

Because of its humble beginnings as a passively managed fund that tracked a particular index, ETFs are often regarded as a quick entry to an uncomplicated investment. But as the variety of funds listed above indicates, the scope of ETFs is expanding. There are currently 1,500 ETFs listed on the Canadian and US stock exchanges, and if the growth of 2018 is any indication, that number will go much higher this year. Funds are being created in all sorts of niche investing areas, and some ETFs are now being actively managed and no longer just track an index. There are now even Exchange Traded Funds that track other ETFs.

So how do you decide whether or not in invest in ETFs?

Before you make investment decisions of any sort, you should have clear goals and a plan to achieve them. You also need to be honest about the time, skill and energy that you have to devote to managing your investments. A trusted, knowledgeable, unbiased ally can guide you towards an investment strategy that fits your overall financial plan and personal preferences. If you want 2019 to be the year that you take charge of your financial future, request a consultation with one of our Money Coaches.

This post first appeared in 2018. It has been updated with current data and/or information and republished.

 



Category(s): Financial Literacy, For your information, Investing
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5 Responses to Exchange Traded Funds: Everything You Wanted to Know But Were Afraid to Ask

  1. David Toyne says:

    An additional downside is actually getting the investment made! Maybe its just the time of year, but I am hearing people spending a lot of time on the phone waiting for an agent at popular discount brokers. I personally waited 28 minutes to speak to someone at TD Waterhouse today. No wonder 4 of 5 discount brokerage accounts opened up are not being funded or traded in. It’s nearly impossible to get someone to help you. So DIYer’s need to be able to trade online as well.
    Also with respect to returns, while much is made about how active mutual funds struggle to meet their benchmarks, many are not even trying (closet indexing) and 100% of ETF’s DO NOT beat their benchmarks. They trail them by the fee, modest as it is.
    I agree with Karin, its a good idea to seek some advice before going down the ETF path. Of course good advice will cost a modest amount that needs to be factored in as well.

  2. ” The cost of purchasing or selling ETF shares through a discount brokerage account is in the 0.05 to .5% range, compared to 2% or more per year on a mutual fund.”
    Karin — don’t you mean the annual cost of HOLDING ETF shares?

    Also, there are some brokerages (Q-Trade being one) that offer no-commission PURCHASES for certain limited popular ETFs. And that can be an advantage (not a cost disadvantage).

  3. Good point Toby. Like mutual funds, ETFs have an ongoing management fee typically in the range of .05 – .5%. There may also be a commission for the purchase or sale of the ETF depending on where and how you buy the investment.

  4. not all ETF’s are passively managed. ETF’s are not necessarily a DIY only investment vehicle. advisors/brokers/planners can and do use them, some exclusively. mutual funds use them.

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