What every investor needs to know about ETFs

Exchange Traded Funds, known as ETFs, are a popular investment choice for investors because they are easy to use and simple to understand.  Whether you’re new to investing or have been at it for years, you should consider including ETFs in your portfolio.  

What is an ETF?

An ETF is an exchange traded fund.  It’s an investment product that is sometimes compared to a mutual fund because both products offer instant diversification, but how they are managed and used in a portfolio can vary. 

An ETF holds a basket of stocks, bonds, or securities that tracks an underlying index.  The securities held within an ETF reflect the makeup of the index it is tracking.  For example, the most popular index in Canada is the S&P TSX 60.  Any ETF tied to this index will hold the same proportion of the stocks that make up that index. This transparency is one of the greatest features of an ETF because it is easy for an investor to optimally diversify when they know exactly what is held within the ETF.

Since ETFs are primarily index-based, they are used by the largest institutions and pension fund managers in the world and are quickly becoming a popular choice for everyday investors.  In July 2020, there were over 800 ETFs for Canadians to choose from, with over $217 billion assets managed. ⁽¹⁾

^{How do ETFs Work?}

Most ETFs are passively managed, which means they aim to match the performance of a certain index, but do not try to outperform it.  Mutual funds, on the other hand, are actively managed and try to beat the market. They require a large team of analysts to research the securities and actively buy and sell to deliver gains for the fund.

A passive investment strategy means that the ETF will perform the same way the index performs.  As a result, ETFs don’t require as much trading and management as a mutual fund, which keeps costs extremely low.

While it may appear that trying to outperform the market would be a better choice for investors (who wouldn’t want to outperform the market?) the truth is, it can be difficult to do this.  Over time, the stock market goes up, and therefore, a passive investment strategy will go up.

Another key difference is that ETFs trade on the stock exchange, whereas a mutual fund is bought and sold directly through the mutual fund company at the previous day’s closing price.  By trading on the stock exchange, ETFs offer investors flexibility to trade throughout the day, with trading commissions comparable to stocks.  What’s more, investors don’t need to concern themselves with individual stock selection, because the ETF have diversification baked into the product.

Benefits of ETFs

ETFs are a cost-effective way to build wealth over time, but they also have several other attractive features that make them appealing to any type of investor:

• Lower risk: They are not risk free, but may be less risk than single stocks or mutual funds
• Access to any asset class: the versatility of ETFs is endless
• Diversification: You can build a complete portfolio with a just a few ETFs
• Inexpensive: In Canada, ETFs cost a 1/3 or what you would pay for a mutual fund
• Easy to trade: Any discount broker or robo-advice platform sells ETFs
• Transparent: You can see exactly what is held in the ETF at anytime
• Simple to use: No complex management strategies
• Accessible: anyone can invest in an ETF with just a few dollars

ETFs offer broad market exposure and less risk at a low cost, making them attractive for any investor seeking long term returns.  Coupled with smart stock purchases, ETFs can make powerful contribution to your investment portfolio. 

There are new ETF products are being made available to Canadian investors every day as the ETF market continues to grow.  Innovative features like no fee funds and single-ticket portfolios have only increased the appeal of these products.

If you haven’t yet included ETFs in your portfolio, it’s worth considering them now.

Sources:
1. CETFA Monthly Report, June 2020