How to Invest Your Money » ETFs

What Is an ETF and How Does It Work?

What Is an ETF and How Does It Work?

Exchange Traded Funds (ETFs) have been around for years, with total assets that today are measured in the trillions of dollars. Yet they remain a mystery to many investors. Perhaps you’ve heard friends or family members talking about their ETF portfolios and wanted to know more. If so, you’re in luck. In this article, I’ll cover everything you need to know about ETFs, including how they are different from another popular investment, mutual funds.

What Is an ETF?

ETFs provide investors with a diversified portfolio of stocks and bonds at a very low cost. They are similar to mutual funds in that both are pooled investments that hold a large number of underlying securities, however, ETFs and mutual funds are very different instruments.

Exchange traded funds are traded much like individual stocks and can be bought and sold instantly then the markets are open. Because of this, the trading fees for ETFs and stocks are the same, with some exceptions that we’ll get into later.

Benefits of Investing In ETFs

No single investment type is the perfect fit for every portfolio, and there’s more than one way to achieve long term growth through the stock market. In fact, most financial experts would tell you that the most important decision you’ll make as an investor is not which stock or ETF to buy, but choosing the proper asset allocation for your portfolio.

That said, ETFs have a lot to offer, and their benefits can help you reach your long term financial goals. Here are a few advantages to ETF investing.

Professionally Managed

ETFs are managed by a team of investment professionals. This takes the pressure off of the investor, who can focus on choosing the right asset mix, and keeping up their contributions.

Diversified Investment

Anytime you buy units of an ETF, you are purchasing a large number of underlying stocks and/or bonds. It’s a simple solution that provides the investor with instant diversification without requiring enormous sums of money to invest.

Low Fees

ETFs have very low fees, often a fraction of what you’ll pay on a traditional mutual fund. In fact, low fees may be the #1 benefit to investing in ETFs. A cost savings of 1.5%-2% per year might not seem like much, but it can add up to tens, if not hundreds of thousands of dollars over twenty or thirty years.

Market Returns

If your goal is to earn market returns, an ETF will get you there. That’s because, when you purchase an index ETF, you are essentially buying the market. While anything can happen in a given year, over the long term, the markets will always outperform other types of investments, such as GICs or bonds.

Can Be Bought and Sold Like Stocks

ETFs are highly liquid in that they can be bought and sold at any time during market hours. Even mutual funds can only be traded once per day. ETFs have an advantage over other, less liquid investments too, such as term deposits, or real estate.

Different Types of ETFs

It should come as no surprise that ETFs come in a variety of flavours. Let’s take a look at some of the various types of ETFs you can buy today.

Stock ETFs

Stock ETFs track a specific stock or bond market index and are incredibly popular with individual investors. Because they follow a passive management style, they are very low cost, with MERs that can range below .10%/year.

Two leading Canadian stock ETFs are the Vanguard FTSE Canada All Cap Index ETF (VCN), and iShares Core S&P/TSX Capped Composite Index ETF (XIC). Both of these ETFs track a broad market index.

VCN follows the FTSE Canada All Cap Index, which is a collection of small, medium and large cap domestic stocks. XIC tracks the S&P/TSX Capped Composite Index, made up of Canada’s largest companies. More conservative investors have the option of adding a bond index ETF to their portfolio, for income exposure.

Sector ETFs

When you buy a stock ETF, you are often tracking the entire economy of a specific country, like Canada or the US. Sector ETFs allow you to invest in a specific industry within the economy. Examples would be Real Estate, Financials, Utilities, Communications, Consumer Staples, and Health Care. There are multiple ETFs that track all of these sectors, and more.

International ETFs

If you want true portfolio diversification, you need to expand your horizons beyond Canada. This can be easily achieved by purchasing an International ETF to add to your asset mix. Investors have the option of buying ETFs that invest in a large number of economies outside of the US, one specific economy, such as Japan, developed or emerging markets.

iShares Core MSCI All Country World ex Canada Index ETF (XAW) and Vanguard FTSE Global All Cap ex Canada Index ETF (VXC) are two examples of International ETFs available to Canadian investors. In general, MERs tend to be a little bit higher than a regular Canadian stock ETF.

Thematic ETFs

In recent years, thematic ETFs have become more popular. These are funds that are designed to appeal to a very specific group of investors, who have a special interest in a particular company or industry. Passionate about video games? There’s an ETF for that.

The Global X Video Games & Esports (HERO) lists Nintendo as its top holding. Meanwhile, the Horizons Marijuana Life Sciences Index ETF (HMMJ) has capitalized on the legalization of marijuana in Canada, and the hope that the similar laws will be relaxed south of the border in the coming years.

While thematic ETFs might sound tempting, they should not be considered as a pillar of any portfolio. The MERs are much higher than broad based stock index ETFs, and they are inherently high risk, as a result of their narrow focus.

ETFs vs. Mutual Funds: How to Tell the Difference

In some ways, ETFs and mutual funds are very similar. Thousands of investors pool their money into a single fund, which is then used to purchase a large number of individual stocks and bonds. Like mutual funds, ETFs are professionally managed and provide investors with a diversified investment portfolio. ETFs are passive investments that track an underlying index, and there are index mutual funds that are also passively managed.

But for all of their similarities, they are in fact quite different. For starters, ETFs are traded like stocks on the exchange. You can buy or sell an ETF instantly when the market is open, whereas, with a mutual fund, orders are filled after the market closes, at the fund’s final unit price.

ETFs have lower fees than traditional, active mutual funds. It’s not uncommon for a mutual fund to have an MER of over 2% per year, while the fees for many popular ETFs are below .10%. As such, the cost savings of owning ETFs vs. mutual funds over the long run cannot be understated.

Most mutual funds are actively traded. This means that the fund manager is trying to outperform a market benchmark by adjusting the holdings of the fund on a regular basis. This active management style requires substantial oversight, which is reflected in the annual expenses of the fund ie. higher fees.

With an ETF, the goal is to mirror the performance of the underlying market index, which requires much less activity. The fund manager is essentially buying the index, and not making regular trades. This is how they are able to keep the costs down.

The idea behind passive investing is that, while it’s been done on occasion, most experts will not outperform the market over time. This is especially difficult when you have to make an extra 2% to cover investment fees. So why try to beat the market? It’s much less complicated to buy the index, and let the benefits of time and compounding take over.

How to Invest In ETFs

There are a couple of ways the average investor can purchase ETFs. The first is to purchase them through a discount brokerage account. These accounts are offered by all of the big Canadian banks, and there are a number of independent brokerages you can choose from as well.

ETF Investing with Questrade

Our top choice here at MapleMoney happens to be Questrade, which is not one of the bank-owned brokerages. We love Questrade for it’s low fees. In fact, it’s one of the only brokers offering commission-free ETF purchases. This is significant, as trading fees can take a substantial bite out of investor returns over the long run. They also offer a robust trading platform, excellent customer service, and an easy to use mobile app.

Get $50 in free trades with Questrade 

Robo-Advisor ETFs

If ETFs sound appealing, but you don’t like the idea of doing your own research and placing your own trades, you can have a customized ETF portfolio selected for you by signing up with a robo-advisor. As Canada’s leading robo-advisor, Wealthsimple is an obvious choice, while the aforementioned Questrade offers something similar with its Questwealth portfolios.

You will pay a slightly higher fee for the added convenience, but robo-advisor ETFs are still much cheaper than an actively traded mutual fund. And the name robo-advisor doesn’t mean that you can never consult with a human regarding your portfolio. Wealthsimple has a team of advisors you can speak to when you need advice.

Get $10,000 managed for free with Wealthsimple

Final Thoughts on ETF Investing

Exchange traded funds are an ideal choice for any investor who values low fees and long term growth. While there are hundreds of ETFs to choose from, I recommend starting with a stock or bond index ETF that is properly aligned with your asset allocation. Of course, you should always speak with a professional advisor before making a final decision. Once that’s done, there’s no better time to start than the present.

Leave a reply

Your email address will not be published. Required fields are marked*