Understanding Exchange Traded Funds

Since they were established on the Toronto Stock Exchange in 1990, exchange traded funds (ETFs) have evolved from an obscure investment tool to an investment vehicle that attracts billions of dollars’ worth of assets annually. Vanguard is one of the world’s leading ETF issuers alongside other big-name providers like BackRock’s [BLK] iShares, Charles Schwab [SCHW], and Invesco [IVZ].

Through ETFs, you can obtain instant diversification, gaining exposure to the Russell 3000 Index or S&P 500 Index with a single transaction. Investors can also lower expenses by holding these funds—since most of them are passively managed and don’t carry the same fees charged by actively managed investment vehicles. ETFs also grant you access to investment strategies that were traditionally only available through hedge funds, such as arbitrage and event-driven strategies.

But are Exchange Traded Funds a perfect fit for your portfolio? Like any investment vehicle, ETFs aren’t a one-size-fits-all type of investment. Today, the financial sages behind MoneyWizard offer up an overview of ETFs—examining their benefits and risks, comparing them to other investment vehicles, and answering some frequently asked questions.

What is an ETF?

An exchange traded fund is typically nothing more than a type of pooled investment fund traded on exchanges like listed company shares, tracking a specific index. The most popular ETFs often track major indices, like the S&P, NASDAQ Composite, Dow Jones Industrial Average, and TSX Composite Index.

Most of these ETFs track individual indices by investing in all, or a small portion, of the holdings of the underlying index. ETFs can also track a sector (like Technology, Basic Materials, etc), represent a commodity (like oil, gold, or wheat), or sample a basket of bonds that meet a certain criterion.

ETFs have become an attractive investment vehicle among traders, and for good reason; they offer the diversification benefits of mutual funds and the ease-of-trade associated with stocks. They also come in many shapes and sizes.

ETFs vs Mutual Funds vs Stocks

You’d be surprised by just how similar ETFs, mutual funds, and stocks really are—only a few key differences set them apart. For starters, ETFs and mutual funds both represent professionally managed “baskets” or collections of individual stocks or bonds. A few other traits that ETFs and mutual funds share include:

• Less risky. Both ETFs and mutual funds come with built-in diversification, which makes them less risky than individual stocks. One fund could include hundreds or thousands of individual stocks—so even if one stock performs poorly, there’s a likelihood that another one is performing well.
• Vast investment options. ETFs and mutual funds let you access a broad range of Canadian and international stocks. You can invest narrowly, widely, or anywhere in between.
• Overseen by professional portfolio managers. ETFs and mutual funds are managed by experts who pick and monitor stocks the funds invest in. While most ETFs and mutual funds track an index, portfolio managers are still present to ensure the funds don’t deviate from their target indices.

Obviously, these three securities aren’t similar—our table below highlights the differences for each to help guide your decision-making process.

Types of ETFs

The ETF spectrum comprises three major fund types, usually based on the specific investment characteristics. The difference between each type of ETF lies in the investment strategy underpinning it as follows:

Passively Managed ETFs

Most ETFs are passively managed—tracking and seeking to replicate the performance of top stock market benchmarks. They are simpler to manage and their lower fee structure makes them a cost-effective way to access the stock market. Passive ETFs are also relatively tax efficient because they don’t require frequent trading and their structure minimizes the capital gains they must distribute.

Actively Managed ETFs

Unlike their passive counterparts that track indices, actively managed ETFs don’t track an index. But how do they work? Usually, a fund manager will select the funds’ stocks—though they must not be publicly disclosed. Actively managed ETFs are designed for investors looking to make some quick plays or beat the market.

An active ETF can subjectively invest in a portfolio of securities and isn’t restricted by the weightings or holdings of an index. It has a portfolio management team whose focus is to outperform the market with different investment styles. Due to their active nature, they’ll have higher management and transaction fees than passive ETFs.

Smart Beta ETFs

Between active and passive ETFs there exists an incredible blend in smart beta ETFs, which use a systematic approach when selecting stocks. Smart Beta ETFs also track and index but focus on several key aspects in determining which stocks to pick instead of using market caps like in index construction. The portfolio managers select assets based on an underlying risk, style, or size that they each share. The aim is to enhance returns without using derivatives or leverage. Holdings must also be disclosed on a daily basis.

Your preferred ETF investment strategy is just as good as the ETF subtype you choose—knowing the various subtypes will help you find the perfect fit for your portfolio. The two main subtypes are equity ETFs and non-equity ETFs.

Equity ETFs include:

• International ETFs own stocks in companies headquartered outside of Canada.
• Sector ETFs own stocks in companies offering similar services and products or pursuing similar types of business, like utilities, energy, or technology.
• Market-cap index ETFs pick and weigh stocks based on the size of each company’s market capitalization—total value of shares.
• Dividend ETFs own stocks in companies with a rich history of paying out dividends to shareholders.

The main non-equity ETFs are:

• Commodity ETFs provide exposure to raw materials like natural resources, metals, or agricultural goods.
• Bond ETFs provide exposure to a portfolio of bonds issued by private companies, government treasuries, municipalities, and other financial institutions.

How ETFs Work

Exchange traded funds work just like their mutual fund counterparts except they’re listed and traded on a regulated stock exchange—usually via a brokerage account. You can also trade them at any time during the normal trading hours.

ETFs have dual existence in the marketplace—the primary market and secondary market. In the primary market, certain institutional investors create and redeem ETFs—and in the secondary market—individual investors buy and sell them. Although most investors will probably trade only in the secondary market, let’s shed light into what happens in both markets.

The primary market participants are ETF sponsors, dealers, and market makers—they create ETFs that trade on a stock exchange. After the dealers create ETFs, they sell them to individual investors in the secondary market, which is the stock exchange.

ETFs trade at the current market prices whenever the stock exchange is open. The prices often reflect the approximate value of the ETF’s underlying securities—but could be more or less than the net asset value (NAV) of the underlying securities. Factors like the currency exchange-rate movements, share-price movements of underlying securities, and demand for the ETF influence the pricing.

Pros and Cons of ETFs

Pros of ETF Investment

Some of the reasons why you should consider an ETF investment include:

• Liquidity. A standout benefit of ETF investing is liquidity—how easy it is for you to purchase and sell a particular asset. Since ETFs are traded like a share on the stock exchange, they’re exposed to the high trading activity. Trading liquidity also lets you alter your investment strategy at any time by pulling your funds out of the asset.
• Low costs. Compared to mutual funds, exchange traded funds usually have lower costs. Mutual funds typically incur costs in the form of shareholder accounting expenses, management fees, service charges, sale and distribution fees, and more. However, you can trade ETFs directly and commission-free on an exchange—but they may be subject to commissions depending on the brokerage.
• Target investing. Some ETFs replicate the performance of indices in specific market segments, like large international companies or specialist types of bonds. This is an important aspect if you’re looking to construct a portfolio that matches your investment objectives. For instance, you’d target Technology ETFs because you’re keen on the 5G revolution.
• Portfolio diversification. An ETF gives you broad diversification across the entire market by pooling most or all securities in the index. Holding a large base of assets helps ensure that you’re exposed to the top-performing market segments—which may offset the underperformance in others.
• Tax efficiency. The lower turnover and redemption process employed in ETFs makes them more tax efficient than mutual funds. ETFs have lower tax obligations because they typically pass fewer capital gains to the investors.

Cons of ETF Investment

Some of the potential drawbacks in ETF investing include:

• Potentially large bid/ask spreads. When you buy or sell ETF shares, the price you’re given could be less than the underlying value of the ETF’s holdings. This discrepancy (the bid/ask spread)—though considered minuscule—may be larger for niche ETFs that have minimal trading activity.
• Commissions. Similar to any other exchange-traded security, you’ll pay a commission each time you buy or sell an ETF. These commissions could rack up with time and become cost prohibitive. And while not all brokers will charge you a commission, be sure to check before trading.
• Some may be complicated. Some ETFs may be more sophisticated based on their holdings or strategies. Be sure to evaluate the features, benefits, risks, and performance characteristics before investing in an ETF.

Frequently Asked Questions

Why an ETF Instead of Individual Stocks and Bonds?

Understanding how ETFs, individual stocks, and bonds compare will help you determine which investment vehicle matches your goals. But, why is an ETF the right vehicle for you?

• Instant diversification. ETFs invest in dozens or even hundreds of companies, so they typically have built-in diversification. A bunch of good performing stocks could offset one poor performing company.
• Market exposure. The broad range of ETF types gives investors easy yet vast exposure to different markets and securities. While most ETFs provide exposure to stocks, you could also invest in ETFs that focus on other asset classes like bonds, a mix of bonds and stocks, commodities, and currencies.
• Research and legwork. Since ETFs are professionally managed based on the objectives outlined in the prospectus, most of the research work, purchase, and sale of individual stocks is done for you. Of course, you’ll need to decide which ETF to buy—but this isn’t as time-consuming or difficult as researching individual stocks.

Why an ETF Instead of a Mutual Fund?

On one level, both ETFs and mutual funds do the same thing—facilitating access to underlying investments. However, these investment vehicles are just as different as they’re similar. Here are some reasons why an ETF is more suitable than a mutual fund.

• Greater flexibility. ETFs are primarily traded like stocks—you can do things with them you can’t do with mutual funds, such as placing stop-loss orders or limit orders, buying them on margin, and writing options against them.
• Tax efficiency. ETFs are typically more tax efficient than mutual funds due to the way they interact and their capital gain proceeds.
• Transparency. ETFs are typically disclosed on a regular basis, so investors understand the nature of their investments. This is contrary to mutual funds, which disclose their holdings quarterly—and there’s a 30-day lag.
• Intraday trading. You can sell and buy ETFs at any time of the trading day. If the market’s falling apart, you can jump out at 11 a.m. With mutual funds, you must wait until the trading day closes – this may be a costly delay.

How to Buy an ETF?

You’ll need a brokerage account to trade ETFs. And depending on what you’re saving for, you could choose a normal or discount brokerage account, a retirement account, or a trust account. It shouldn’t take more than 10 minutes to open an account online, after which you should fund your account. While most accounts have no preset minimum, the money you add should cover the cost of the ETF shares you’re looking to buy.

Now, you may start researching and comparing your ETF options. You can buy your preferred ETF just as you’d do with stocks—placing a trade using the ticker symbol.

Do ETFs Pay Dividends?

ETFs often make monthly capital gain distributions in the form of dividends. Depending on the ETF, these dividends may be paid at some other interval. The 2 basic types of dividends are qualified and non-qualified dividends. Qualified dividends are paid on stock held by an ETF for more than 60 days while non-qualified dividends may be payable on stocks held for less than 60 days.

Are ETFs Safer Than Stocks?

ETFs are relatively safer than stocks because most of them are index funds—they offer instant diversification and can easily bounce back from the worst of market crashes. You can also limit your investment risk by investing in industry-specific ETFs.

Do You Have to Pay Taxes on ETFs?

Investors are subject to capital gains tax—but only when a capital gain is realized after selling an ETF. However, ETFs are structured in a manner that minimizes taxes for the ETF’s holder. Therefore, the ultimate tax bill will be lower than what you’d have paid with a similar mutual fund. ETF dividends are also taxed based on how long an investor has owned the ETF fund.