Exchange-traded funds, or ETFs, are a type of investment that has increased in popularity in recent years. Not only do ETFs allow you to own a variety of investments such as stocks and bonds, but they typically have low management fees.
Benefits of investing in EFTs include portfolio diversification, convenience and a flexible management style, but understanding how ETFs work and how they fit into your portfolio is paramount before you purchase them.
What is an ETF?
ETFs are investment funds that allow you to purchase a “basket” of products such as stocks, bonds and guaranteed investment certificates (GICs). They’re similar to mutual funds, but there are a few key differences.
With mutual funds, portfolio managers use a strategy known as active management, in which they actively trade stocks in and out of the fund in an attempt to maximize gains.
In contrast, most ETFs use a passive management approach. Algorithms handle the trading, and the goal of most ETFs is to simply track an index or sector.
Since ETFs have human managers, their overhead costs are significantly lower than those of mutual funds. Those savings are passed on to investors in the form of a lower management expense ratio, orMER.
How ETFs work
With ETF investing, fund providers such as Vanguard, iShares and the Bank of Montreal own the underlying assets.
As an investor, you buy into the ETF portfolio. Your share of the ETF gives you access to dozens or even hundreds of stocks and bonds, though you don’t own each one individually.
ETFs are appealing, especially to beginner investors, since they allow you to own a diversified portfolio with a single investment product. Most ETFs are designed to track a specific sector or index, such as the S&P 500 or TSX Composite Index.
Some ETFs pay out any dividends or interest from individually held investment products. ETF dividends are typically paid quarterly. ETF owners can take the dividends in cash, or ask their brokerage or advisor to automatically reinvest them.
Types of ETFs
If you’re interested in ETF investing, you’ll want to become familiar with the different types of ETFs available, including:
- Market or index ETFs, which track a specific index such as the NASDAQ.
- Bond ETFs, which give you access to different types of bonds, such as government, corporate, and high-yield.
- Industry or sector ETFs, which track sectors such as energy, technology and health care.
- Commodity ETFs, which track the price of commodities such as gold or oil.
- Real estate ETFs, which include multiple real estate investment trusts (REITs), allowing you to have exposure to multiple investment properties without being a landlord.
- Currency ETFs, which include currencies from around the world.
- Leveraged ETFs, which use derivatives and come with higher risk, but these types of ETFs are designed to give you higher potential gains.
- Actively-managed ETFs, which are designed to try and outperform an index, rather than simply tracking it.
How to buy an ETF in Canada
Many ETF investors choose to start investing in ETFs directly through their brokerage accounts. Most brokerages will charge a commission fee (usually $10 or less) whenever you buy or sell an ETF. However, some brokerages only charge a fee when you sell your ETFs. In other words, ETF investing can be done at a very low cost if you strategically choose your brokerage.
Another way to buy ETFs is through a robo-advisor or investment advisor. In both scenarios, the choice of ETFs will be based on your risk profile. Since you’re using a third party to purchase the ETFs for you, you would pay a management fee on top of the MER charged by the ETF.
ETF pros and cons
Even though ETFs allow you to diversify your portfolio at a low cost, you still need to consider their advantages and disadvantages.
Pros of ETF investing
- Diversification: Purchasing a single ETF can give you access to a large pool of stocks and bonds that spans an entire industry, country, or the entire world.
- Low cost: ETF management fees are significantly lower than those of mutual funds.
- Passive investing: Most ETFs use a passive approach, so your returns will typically be similar to the underlying index or sector that your ETF tracks.
- Low effort: ETFs are attractive to people who have no interest in purchasing individual stocks or bonds and actively managing their investments.
Cons of ETF investing
- Average returns: Since ETFs are designed to track an index or sector, your returns are unlikely to beat the benchmark.
- Some experience may be required: To further minimize costs, you’ll need to open a discount brokerage account so you can buy and sell ETFs on your own.
- Tracking error: Although ETFs mostly track their underlying indexes quite well, there is sometimes a slight discrepancy.
Frequently asked questions about ETFs
ETFs are safe in the sense that they are made available from reputable providers. That said, purchasing an ETF, like any other investment product, doesn’t mean you’re guaranteed a return. And, like other investments, there’s always the risk that an ETF will decrease in value, resulting in a financial loss. It’s also worth noting that past ETF performance does not indicate future results.
ETFs are among several investment choices that make sense for beginner investors in Canada. Lower costs, reduced volatility, and hands-off management are among the reasons that new investors find ETFs appealing.
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