What are ETFs?
With the recent surge of DIY retail investors and low-cost online brokerages, it isn’t surprising that the demand for low-cost exchange-traded funds (ETFs) would increase exponentially as well. Just like when investors flooded transparent ETFs in the economic fallout of the 2008 financial crash, retail investors have again begun looking towards ETFs following the 2020 COVID crash.
In fact, when comparing ETFs vs mutual funds in 2020 it is estimated that US$497 billion of new cash entered ETFs while a record US$506 billion was withdrawn from mutual funds.
But why ETFs? The easy answer is that they are a low-cost, low-effort, hassle-free pathway into investing. Before you jump into ETF investing, however, you need to understand what ETFs are.
This article covers the ins and outs of exchange-traded funds, including why you should consider investing in ETFs and how you can safely start doing so.
ETFs: Key takeaways
What is an ETF?
An ETF is a collection of securities (stocks, bonds, commodities, crypto etc.) combined into a single purchasable fund. Combining assets into one basket allows investors to buy multiple different assets in a single trade. ETF stands for Exchange Traded Fund because the fund itself is traded on exchanges just like stocks. They are often created by fund management companies to mimic the composition of major exchange indexes like the S&P500 or the Canadian S&P/TSX Composite Index.
While ETFs are famously known to be passive index trackers, ETFs can contain any type of asset class from stocks to bonds or commodities. In addition, ETFs also exist which are specific to certain industries like technology or renewable energy, as well as being comprised of mixed asset classes and spanning several geographical regions.
A financial advisor, robo-advisor or brokerage platform is all you need to get started investing in ETFs.
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How do ETFs work?
ETFs work by simplifying the investment experience for the average investor by removing the need to invest in multiple assets individually. The fund manager, also known as the ETF provider, puts together a basket of assets depending on certain criteria and gives the newly created ETF a name. The name represents the composition of the fund such as the iShares Core S&P/TSX Capped Composite Index ETF, which is an ETF composed of stocks from the Canadian S&P/TSX index.
Investors that are interested in investing in the specific basket of assets within a created ETF can do so. Just like buying shares of a company, ETF investments take place on stock exchanges.
Pros of ETFs
- Instant diversification reduces overall risk
- Easy geographical distribution
- Low costs
- Minimal to no broker commissions
- Targeted ETFs are available
Cons of ETFs
- ETF expenses are higher than investing directly into assets
- Potential false sense of diversification
- Lack of liquidity in less traded ETFs
- Won’t outperform any given market
How do you buy an ETF in Canada?
To buy an ETF in Canada you will need access to a trading platform through a brokerage account since ETFs are traded on stock exchanges. There are numerous discount brokerages in Canada. A comparison of the best can be found in our online brokerage guide.
Once you have an online broker account you will receive access to a trading platform where you will be able to trade ETFs by buying or selling ETFs of your choice. Most commonly, investors who trade ETFs invest for the long term and build their own portfolios. More hands-off investors can instead opt for a robo-advisor to make investment decisions on their behalf.
If you are not only interested in buying an ETF in Canada, but specifically want to buy an ETF with Canadian stocks, you could consider the iShares Core S&P/TSX Capped Composite Index ETF created by BlackRock. This ETF comprises 230+ publicly traded companies listed on the Toronto Stock Exchange.
Good to know
It is important to note that not all online brokers can sell every ETF. So, when deciding which online broker to use check that the ETFs that you are interested in are available.
Ready to start investing in ETFs? Here's how
Are ETFs safe?
ETFs are fairly safe investments because they are inherently diversified. When you invest in an ETF you aren’t buying shares in one singular company which carries high risk, instead, you are buying into a basket of assets. By doing so, no singular asset has the ability to compromise your entire investment. For example, the Vanguard FTSE Canada All Cap Index ETF includes a total of 182 publicly traded companies. If one of these companies fails it will only have a minimal impact on the total ETF.
However, ETFs are still volatile and you do carry market risk when investing in them. For example, if you chose to invest in a Technology ETF and the overall technology sector decreases in any given year, then your investment will reflect the market trend and you may lose money. That is why it is important to build an ETF portfolio to cover multiple industry sectors, geographical regions and asset classes.
What is an ETF portfolio?
An ETF portfolio is much like a normal investment portfolio comprising stocks, bonds and commodities, with the key difference being that you replace specific assets with an ETF of that asset class instead. You can also choose ETFs based on sectors or countries of interest, as well as entire geographical regions.
Good investment portfolios should include equities from most industries and countries, as well as global corporate and government bonds in addition to commodities such as wheat, silver and gold. The following example ETF portfolio ticks most of these boxes.
- Vanguard Total Stock Market Index Fund ETF Shares (VTI)
- Vanguard Total International Bond ETF (BNDX)
- iShares Core S&P/TSX Capped Composite Index ETF (XIC)
- abrdn Bloomberg All Commodity Strat K-1 Free ETF (BCI)
ETFs vs stocks
The difference in investing in ETFs vs stocks is that with ETFs you will be investing in a bundle of stocks from many companies, as opposed to investing in specific companies directly. If you are trying to choose which will be better for you then you should consider the following.
- Do you have the time to research specific companies?
- Are you interested in, or know enough about finance to research the potential upsides of specific companies?
- Is your investment goal to achieve better-than-average returns?
- How would you feel if your investments dropped 10%, 20% or even 30% in the space of a month?
If you’re still unsure you can compare your answers to the above questions with the pros and cons of investing in ETFs vs stocks below.
Why pick ETFs over stocks
- Mitigate risk and reduce volatility
- Build a diversified portfolio with relatively low investment amounts
- Invest for the long term
Why pick stocks over ETFs
- Try to beat the market
- Invest in specific stocks
- Avoid all costs
It is easy to start investing in ETFs. Here's how
What types of ETFs exist?
Many different types of ETFs exist in order to fulfill the various and specific needs of investors. Some can be complex while others are simple. For example, if an investor is looking to generate steady income from their ETF investment they may consider a dividend-paying ETF or bond ETF, but if they want to invest in just renewable energy they would pick an Industry or Sector ETF specific to their needs.
The most common types of exchange-traded funds include Stock ETFs, Industry/Sector ETFs, Commodities ETFs and Bond ETFs, while lesser-known ETFs include Leveraged ETFs and Inverse ETFs.
What is a stock ETF?
A stock ETF, or equity ETF, gives investors exposure to a specific set of publicly traded stocks. While stock ETFs are usually more volatile than bond ETFs in the short term due to the volatile nature of stocks, they are usually suitable for long-term investors.
Since equity ETFs are often divided into several different sectors and categories, investors can easily find the type of stock fund that meets their specific criteria. For example, the ARK Innovation ETF would be a great fund choice for anyone wanting to invest in disruptive innovation.
What is a leveraged ETF?
Leveraged ETFs use both shareholder equity and debt to try and increase returns to shareholders of the leveraged fund. By maintaining exposure of $2 or $3 to the underlying index for every $1 of shareholder investment, the leveraged ETF will specifically try to achieve double or triple returns, respectively.
For example, if a triple leveraged ETF tracks the Canadian S&P/TSX Composite Index and the index rises by 1%, the leveraged ETF will rise by 3%. Of course, the opposite is also true. If the index loses 10% of its value over the span of a month, the investor of the triple-leveraged ETF will have lost 30%.
It is the potential for great losses that make leveraged ETFs a riskier investment than a normal ETF and only suitable for experienced traders.
What is the difference between ETFs and mutual funds?
The biggest difference between ETFs and mutual funds is that ETFs are usually passively managed while mutual funds are actively managed. For mutual funds, this means that fund managers actively buy and sell securities within the fund in order to try to beat the market. Passively managed ETFs on the other hand are left for longer periods of time without restructuring.
Due to the actively managed style of mutual funds, they usually have higher fees and expense ratios than their ETF counterparts. Some other key differences between ETFs and mutual funds are:
- ETFs are traded during the stock market opening hours, while mutual funds are purchased at the end of the trading day
- Mutual funds have high minimum initial investment
- Mutual funds have more tax liabilities
- ETFs have a higher liquidity
- ETFs simply try to match market returns, while mutual funds strive to outperform the market
Understanding your ETF
Exchange-traded funds are excellent investments for beginners due to their many benefits. They are low-cost investment vehicles, offer immediate diversification and have low minimum investment thresholds. However, before investing in an ETF you need to understand the specifics of the ETF itself.
What is the MER/Expense Ratio in an ETF?
MER stands for management expense ratio and is the total cost for administering and distributing an ETF. Used interchangeably with the term expense ratio, the MER is the cost investors pay for the privilege of buying an ETF.
If an ETF lists its MER as 0.3% and the investor has $10,000 invested in that fund, it will pay $30 every year in fees. Similarly, if an MER is as high as 1% the investor will pay $100 on the same $10,000 investment.
Apart from MERs, investors will often face another charge when buying ETFs which is called a dealing cost. Dealing costs vary depending on your online broker and need to be considered before making any ETF trade.
What is NAV in an ETF?
The Net Asset Value (NAV) of an ETF is the value of all the assets held by the fund, less any liabilities, divided by the ETFs shares outstanding. The NAV is usually expressed as the value per share and provides a good indication of the fair value of a single share of an ETF. Investors can use the NAV as a reference point when considering either buying or selling shares of an ETF.
What does yield mean in an ETF?
The yield, or distribution yield, of an ETF, is the amount your investment is expected to earn during a specific time period. The yield is listed as a percentage and represents the amount of cash paid by the ETF to its investors over the course of a year.
Since the yield of an ETF provides a cash benefit to investors regardless of how the fund performs, those looking for a fixed income should consider ETFs with a higher yield.
What is AUM in an ETF?
AUM stands for assets under management and represents the total amount of money invested in a specific ETF. When investors buy or sell their shares of an ETF, the AUM will fluctuate accordingly.
When considering which ETFs to trade, the size of the AUM provides good insight. For example, funds with larger assets under management have greater liquidity and are more easily traded. In addition, larger AUMs often indirectly indicate that an ETF is of higher quality as it will likely have existed longer and come with a better track record.
What is a capped ETF?
A capped ETF is an exchange-traded fund with defined upper limits on the weighting of any single stock within the ETF’s composition. For example, an ETF with an 8% cap rule stipulates that no single stock can account for more than 8% of its combined index.
Investing in a capped ETF is a good option for risk-averse investors because the cap reduces an investor’s exposure to risk which is one of the main benefits of ETFs.
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