Exchange Traded Funds (ETFs)

These days there are so many new investments types coming into the market, its hard to keep track of everything. Over the last few years we've seen a huge surge in something called "Exchange Traded Funds" (ETFs). Although they aren't very new to the industry (have been around for more then a decade), it seems like only in the last 4 or 5 years they have started to make a name for themselves. In this post I will go over the basics of this type of investment, the types of ETFs, the pros and cons, and also the type of investor who I feel would benefit most from it.

What is an ETF?

An exchange Traded Fund is like a mixture between a stock and a mutual fund. It works similarly to a stock because you trade on the stock exchange through a broker. And, like a mutual fund, you can purchase a group or basket of stocks (or other investments) rather then purchasing one at a time.

ETFs are designed to mimic the index or a sector. For example, you can own an ETF that mimics the S&P/TSX index. This means it will hold pretty much the same things and same weightings as that index. Because they are just tracking the index or a sector, the fund manager doesn't really have to do the buying/selling or analyzing/researching that a normal mutual fund manager has to do - thus lowering the fees associated with this investment (the MER).

ETFs are bought/sold on the market and can be sold at any time of day, just as a regular stock can be done. However, unlike stocks, you don't really have to watch and track them everyday, since its following the overall index. Just as regular mutual funds, these should be used as a long-term, buy and hold, type strategy. Unlike mutual funds though, you have more flexibility of when/how you buy and sell.

Types of ETFs

There are a few different type of ETFs that can be invested in and here are just the main ones.

1. General Index ETFs - Similar to an index mutual fund, these funds track the broad indexes such as the S&P/TSX Composite Index. This will track the largest companies on the index, and will invest over different sectors/industries.
2. Sector ETFs - These funds basically just track a specific sector within the Index, such as technologies or financials, but can also go into commodities such as gold or silver.
3. International ETFs - These funds can track indexes in other countries, for example USA, and will give you exposure to them. You can also get an 'emerging markets' ETF that will give you access to multiple international markets.
4. Fixed Income ETFs - Similarly to a fixed income mutual fund, these funds will invest directly into fixed income investments. However, these ETFs will follow the actual bond index itself.

Pros and Cons of ETFs

Pros:

• Cost: Generally, ETFs will have lower MERs (fees) then regular mutual funds. This is because there much research/analyzing and buying/selling that a regular mutual fund would have, thus less work for the fund manager.
• Flexibility/Liquidity: Since ETFs trade on the stock market, you can buy/sell at any time of the day (as long is there is someone to buy/sell from you). This is in contrast to a mutual fund, where the trade cannot be done until the end of the day, at which point the market could have fluctuated a lot.
• Performance: Rarely do I discuss performance, because that can always come back and bite you in the behind since no 1 fund will always outperform. However, when it is something more consistent, then it should at least be taken into consideration.
• Taxation: Although inevitably you will have to pay taxes on your ETFs, you can often delay the taxation if you buy and hold. With an ETF, you will pay taxes on any annual dividends (whether received in cash or redistributed - same as a mutual fund), but other then that, you will pay taxes on gains only when you sell the ETF. In a mutual fund, capital gains taxes are incurred as the shares within the fund are bought/sold during the lifetime of the investment (since other people who are in the fund will be buying/selling over the time) AND there will be a capital gains tax when the fund is actually sold by you (if sold for more then you purchased for).
• No Minimums: With ETFs, there are no minimums to start investing (are there are with SOME mutual funds). You can start off with a minimum amount (although its not recommended due to brokerage fees), or as large an amount as you want.
• Short Selling: This, in my opinion, is something for more sophisticated investors. ETFs offer the ability to short-sell, or in other words, betting on a decline on the index that the fund is tracking. In a way, this is a little more of a gamble, but if an investor has taken the time and energy to do all the research and highly feels that the market will go one way or another, they can take advantage of an opportunity they feel is coming.

Cons

• Costs: Although one of the pros was lower MER costs then a traditional mutual fund, brokerage fees are something that MAY negate (and then some) the savings in MER if there is a regular contribution (i.e. monthly, weekly, bi-monthly). For example, if a brokerage is charging $15 per transaction (either buy or sell), and there is a monthly contribution, this means the total annual charge in just brokerage fees will be $180 (and then another $15 when you sell) . Note, this does not include the MER.
• Lack of Liquidity: Again, also listed as one of the benefits, this can also be a weak point of ETFs. Since they are traded on the exchange, in order for one ETF to be sold, there must be a buyer. In some cases, there might be a challenge when trying to sell with limited or no buyers on the market.
• Lack of Professional Management: Mutual Funds have become famous because of the professional and active management they offer. Since ETFs mimic the index, there isn't much decisions that fund managers need to make. This can be a downfall where actively managed mutual funds can spot opportunities to buy/sell certain investments where they see fit, thereby in theory, reduce risk and/or enhance potential for higher returns. Essentially, the investor would pretty much have to do the bulk of the research/analysis on each of the ETFs to make sure they are keeping up with all the opportunities within the market. Most
• Spreds: When you conduct a buy/sell order, you have to pay a "spred" - the price at which you can buy is slightly higher then the price at which you can sell. Whoever is executing the trade in the stock market for you is basically just pocketing the difference. Therefore, you are not getting the full benefit from your trade as part of the money is going into someone else's pocket.
• Dividend Re-investment: Many ETFs will offer a dividend component which will give the investor dividends in cash. With Mutual Funds, you can directly invest the dividends back into the fund, however, ETFs do not do that. This might not allow an investor to take full advantage of purchasing additional shares/units of the ETF to maximize growth. Some brokerages are now starting to introduce a DRIP (dividend re=investment program), but not all do. Also, when re-investing the dividend, many brokerages are charging a fee for the transaction. This could further deteriorate/minimize the growth potential in the fund.
• No Guarantees: There are no guarantees in what you will get as a return when you purchase ETFs. For an investor who is risk averse, this might not be the proper type of investment for them. As opposed to something like a Segregated Fund that offers a principal maturity and death guarantee, ETFs do not have any of those type of features, which could make it a more riskier investment for many investors.
• Fund Switching: With ETFs, there cannot be any direct 'switching' from one fund to another, instead, there has to be a sell order of one fund, and then a buy order of another. Any time this is done outside an RRSP or TFSA, there is a chance of taxes (if there are any capital gains), which will hinder the growth of the portfolio, especially if there are several changes done throughout the lifetime of your portfolio. Whereas, with mutual funds, you can have fund switching without causing any taxation (if the fund is structured as corporate class). Over the lifetime of an investment portfolio, this can add up to a LOT of taxes which can drastically reduce the overall return of the portfolio. Also note that any time there is a 'fund switch' there will be buy/sell fees associated from the brokerage.

As stated many times before, there is no ONE strategy that is best for everybody. ETFs can be a great way to get returns and outperform many other mutual funds, but if used, they should be done so in a knowledgeable fashion. I would say, generally, that ETFs are more for sophisticated investors who have the time, patience, and understanding capability of the market and its trends. This would be more stressed if an investor was to invest into things like commodities, since they tend to be more risky. Also, this is not a strategy that should be used with a regular contribution plan (for example monthly contribution) because of the fees associated with brokerages.

If an investor can only do regular contributions, it would be recommended to put those smaller regular contributions into no-fee/no-load mutual fund until it reaches a larger lump sum (i.e. maybe $5,000 or $10,000), and then transfer that larger balance directly into an ETF. This way, the per transaction brokerage fees are avoided, and an investor can take full advantage of the lower MERs.

Although ETFs would be a great addition to an investment portfolio, please consult a knowledgeable financial advisor in regards to how it might fit into yours. Just as mutual funds, there are many different types of ETFs, and each should be analyzed carefully. One thing to also note is that many Mutual Funds do actually use ETFs within their portfolios (usually a small portion) to take advantage of certain opportunities, so as an investor, both can be used to compliment eachother.

I hope you have learned something from this post, and if you have any questions, please do not hesitate to contact me.