Some investors are yet to understand the concept of exchange-traded funds (ETF), especially in relationship with mutual funds and stocks. Other investors simply understand ETF as an investment that looks like mutual funds but trades like stocks in the market.
Exchange-Traded Funds (ETF) Defined
ETF is an investment fund, a collection of securities sold on an exchange that combines the features and potential benefits of stocks, mutual funds, and bonds. ETFs provide investors a low-cost way to build a broadly diversified portfolio rather than buying individual securities. ETFs are passively managed; they can be sold short and bought on margin.
Originally, ETFs were organized as Unit Investment Trusts (UITs). In a UIT, an investment company can buy a fixed portfolio of securities and then sells shares of that portfolio to investors.
This type of structure results in dividends being held in an interest-bearing account, from which they are deposited into the ETF, generally once each quarter. The delay in investing dividends can have a slightly negative effect on the total return of the ETF because the dividends are held as cash instead of being invested.
Other ETFs are structured as open-end funds. This arrangement follows the typical mutual fund structure such that new shares are continually offered and redeemed by the investment company. An open-end structure allows dividends to be reinvested immediately.
Similarities Between ETFs and Mutual Funds
- Both consist of a mix of many different assets and offer the opportunity to invest in a portfolio of securities (stocks and bonds).
- Both may track an index and can be actively or passively managed.
- ETFs and Mutual Funds that track indexes often contain several securities providing greater diversification.
Differences Between ETFs and Mutual Funds
Flexibility – ETFs are traded on stock exchanges around the world, including TSX. That offers investors the flexibility to trade units whenever the exchange is open. Like stocks, ETFs are sold at real-time prices and traded throughout the day. On the other hand, mutual funds do not have this flexibility: Their pricing is based on end-of-day trading prices.
Expenses – Mutual funds have higher expense ratios than ETFs due to the higher cost of Mutual Funds being actively managed.
Tax Efficiency – ETFs may be more tax-efficient than some traditional mutual funds: managers of index-based ETFs only make trades to match changes in their index, which may mean greater tax efficiency.
Purchase Period – Unit prices vary throughout the day, moving up or down depending on changes in the prices of the underlying securities and supply and demand for the ETF units themselves. However, in contrast, all purchases and sales of mutual fund units are executed only at the end of the trading day—at the same price for all investors.
Purchase medium – Investors must trade ETFs through a brokerage firm, a discount brokerage account, or a platform offering brokerage services. However, mutual funds can be bought and sold directly through a fund company trying to outperform its benchmarks.
Minimum investment — Most mutual funds require a minimum investment, whereas an investor can usually purchase as few shares of most ETFs as desired.
Types of ETFs
The most common ETFs are discussed below:
- Diversified Passive Equity ETFs
These types of ETFs are designed to mirror the performance of widely followed stock market benchmarks such as the S&P 500, the Dow Jones Industrial Average, and the MSCI Europe Australasia Far East (EAFE) indexes. Hence, major index-based ETFs tend to follow their performance benchmarks closely.
- Niche Passive Equity ETFs
These ETFs, such as those that mirror the sector subsets of the S&P 500 or the small companies of the Russell 2000, may offer investors focused exposure to help them fine-tune their portfolio strategies. As with diversified passive funds, these niche portfolio funds are generally made up of the same stocks as those used to calculate their reference indexes.
- Active Equity ETFs
This allows their managers to use their judgment in selecting investments rather than rigidly pegging to a benchmark index. Active ETFs may offer the potential to outperform a market benchmark but may also carry greater risk and higher costs.
- Fixed-income ETFs
These ETFs focus on bonds rather than stocks. Major fixed-income ETFs tend to be actively managed but have relatively low turnover and generally stable portfolios
Advantages of ETFs
- Trades throughout the day on an exchange
- No minimum investment amounts
- Potentially tax efficient
- ETFs can be sold short and bought on margin
- Expense ratios are low
Disadvantages of ETFs
- The flexibility of the instrument may encourage frequent trading, potentially negating the tax-efficient edge
- It attracts Brokerage commissions
- Capital gains are occasionally distributed
How to Invest in ETFs
This depends largely on the investor’s choice to be a do-it-yourself (DIY) investor or want to take a more hands-off approach to investing.
- DIY investors
- Open a discount brokerage account
The two self-directed trading platforms we recommend for DIY investors are Questrade and Wealthsimple Trade.
The lowest cost option is at Questrade, where you can purchase ETFs for free, all account types are available to investors, and there are no annual fees, no matter the account size. Their other trading fees range from $4.95 to $9.95, and their account minimum is $1,000.
If you transfer your RRSPs or TFSAs from another institution, Questrade will cover your transfer fee. Questrade offers $50 in free trades when investors open an account with the organization.
Wealthsimple Trade is relatively new on the scene and offers RRSPs, TFSAs, and non-registered (taxable) investment accounts on a mobile-only platform. But Wealthsimple Trade is Canada’s first and only commission-free stock and ETF trading platform, making it an instant hit for cost-conscious investors with basic investing needs.
- Fund the account
The investor needs to contribute to the account from his or her bank. You can do this by linking your bank account to the brokerage account with a one-time lump sum or regular automatic contributions.
- Select your ETF or portfolio of ETFs
Investors can do the selection by entering the ticker symbol(s) and purchasing the appropriate number of units. Unless investors hold an all-in-one balanced ETF, they’ll need to do their portfolio rebalancing and decide on some rules.
For instance, the investor can either rebalance whenever they add new money by contributing to the lagging fund or rebalance once or twice a year by selling some of the top-performing funds and buying more of the fund with the poorest returns.
- Hands-off Approach Investors
This kind of investor can employ the services of financial advisors, individual brokers, or big bank brokerage platforms to trade on ETFs. This process also requires the investor to open a brokerage account with the advisor, broker, or brokerage platform and fund the account given the terms and conditions of the brokerage platform or broker.
Top ETFs for Canadian Investors
Find some ETFs we suggest Canadian investors can key into for significant profit.
|ETF Name||Ticker||MER %||Number of Holdings||Asset class|
|BMO Aggregate Bond Index ETF||ZAG||0.08||1,323||Fixed income|
|Vanguard FTSE Canada All Cap Index ETF||VCN||0.06||181||Canadian equity|
|iShares Core S&P US Total Market Index ETF||XUU||0.07||3,599||U.S. equity|
|Vanguard FTSE Developed All Cap ex North America Index ETF||VIU||0.22||3,728||International equity|
|Vanguard FTSE Emerging Markets All Cap Index ETF||VEE||0.24||4,973||International equity|
|iShares Core MSCI All Country World ex Canada Index ETF||XAW||0.22||8,952||Global equity|
|Vanguard Conservative ETF Portfolio||VCNS||0.25||27,794||Asset allocation|
|Vanguard Balanced ETF Portfolio||VBAL||0.25||27,834||Asset allocation|
|Vanguard Growth ETF Portfolio||VGRO||0.25||27,685||Asset allocation|
|3Vanguard All-Equity ETF Portfolio||VEQT||0.25||12,392||Asset allocation|
|iShares S&P/TSX 60 Index ETF||XIU||0.18||61||Canadian equity|
|iShares Core S&P/TSX Capped Composite Index ETF||XIC||0.06||222||Canadian equity|
|Vanguard FTSE Canada All Cap Index ETF (VCN)||Canada||0.06||202||Canadian equity|
|iShares Core S&P U.S. Total Market Index ETF (XUU)||U.S.||0.07||3,688||US Equity through the S&P Total Market Index|
|iShares Core MSCI All Country World ex Canada Index ETF (XAW)||Global, ex-Canada||0.22||8,924||Equities across 22 developed markets countries (excluding Canada) and 23 emerging markets countries.|
|BMO Aggregate Bond Index ETF (ZAG)||Canada||0.09||1,259||Canadian investment-grade fixed income market consisting of Federal, Provincial and Corporate bonds.|
|Vanguard Balanced ETF Portfolio (VBAL)||Global||0.25||12,595||Global equity (approximately 60%) and fixed income (approximately 40%) securities.|
Every investor should carefully consider the risks of different ETFs to decide to invest effectively. For instance: Government bond ETFs are subject to federal income tax; Many sector ETFs will tend to be more volatile than an ETF that tracks the broader market.
Engaging a financial professional or investment advisor to guide and educate the investor on the risks and provide the investor with updated information before investing in an ETF.