ETFs (Exchange Traded Funds)

by | May 4, 2016 | Financial Planning

These days there are so many new types of investments coming into the market, that it’s hard to keep track of everything. Exchange Traded Funds (ETFs) have been one of these ‘new’ investments introduced into the industry, and we’ve seen a huge surge in their popularity. Although they aren’t very new to the industry (having been around for more than two decades), it seems like only in the last 5-7 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 it trades on the stock exchange, and also like a Mutual Fund, because it is essentially comprised of a group or basket of investments (such as stocks/bonds/cash).

ETFs are designed to mimic an 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 itself. Since they are just tracking the index or a sector, the fund manager doesn’t really have to do much 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, however, unlike individual stocks the risks associated with them are much lower, since the risk is spread across a basket of investments, as opposed to just 1. ETFs can be purchased for short, medium or long term investments, however, unlike Mutual Funds, you have much more flexibility of when/how you buy and sell.

Types of ETFs

There are a few different types 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 or the S&P 500. This will essentially have the same companies and weightings of those companies as the index it’s tracking.
  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 or China, and will give you exposure to them. You can also get something like 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, such as bonds. However, these ETFs will follow the actual bond index itself.

Pros and Cons of ETFs

Pros:

  • Cost: ETFs have much lower MERs (fees) then regular Mutual Funds. This is because there isn’t much research/analyzing and buying/selling that a regular Mutual Fund would have, thus less work for the fund manager. Also, you don’t have to go through a Fund Company to purchase them, which essentially cuts out the ‘middle man’.
  • Flexibility/Liquidity: Since ETFs trade on the stock market, you can buy/sell at any time of the day (as long as there is someone to buy/sell from/to you) – this is called ‘intra-day’ trading. This is in contrast to a Mutual Fund, where the trade cannot be processed until the end of the business day, at which point the market could have had a substantial fluctuation.
  • Opportunities: ETFs are great with providing opportunities to things/markets most people might not otherwise have access to. Because ETFs are essentially tracking an index, there are many indexes a client can invest in (as shown above). For example, investing in a specific industry, geographic location, precious metals or currency becomes very easy with the use of ETFs.
  • Taxation: Although inevitably you will have to pay taxes on your ETFs (unless it’s within a TFSA), 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 than 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, regardless of whether you sold any units that year. This is because other people who are in the fund will be buying/selling over the time, and the tax is spread across the entire pool of investors. With ETFs, you will pay capital gains tax only when the fund is actually sold by you (if sold for more then you purchased for).
  • Short Selling/Inverse Funds: 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. There are ‘Inverse Funds’ that will return opposite what the index it’s tracking does, so if an investor feels that a certain index will move negatively, they can purchase an Inverse Fund and make gains as the index loses. 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 than a traditional Mutual Fund, brokerage fees are something that MAY negate 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). These fees can really add up over the lifetime of the investment and can drastically cut into your returns. That being said, there are several online brokerages that do allow you to buy ETFs commission-free, so if you can get commission-free trades for ETFs, this would not be an issue.
  • 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 aren’t many 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. In most cases, with ETFs, you are your own Portfolio Manager.
  • Spreads: When you conduct a buy/sell order, you have to pay a “spread” – the price at which you can buy is slightly higher than 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.
  • No Guarantees: Similar to Mutual Funds there are no guarantees in your returns or guarantee for your principal. For an investor who is risk averse, this might not be a suitable 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 types of features, which could make it a more risky 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 switch between funds of the same Fund family without triggering any taxation (if the fund is structured as corporate class). Over the lifetime of an investment portfolio, this can add up to quite a bit of taxes which can drastically reduce the overall return of the portfolio. Also note that any time there is a ‘fund switch’ there MAY be buy/sell commission fees associated from the brokerage.

 

ETF Based Portfolios

Over the last several years, there have been more and more companies offering ‘ETF built portfolios’, and it seems to be making great strides. These are essentially portfolios built with a combination of different ETFs, which allow the Portfolio Managers to build customized and diversified portfolios for their clients. What this does is combines the flexibility, low fees, opportunities & tax efficiency features of an ETF, along with the Active/Tactical Management provided by Professional Portfolio Managers. This in turn allows clients to get stronger and more stable rates of returns with reduced cost and volatility. Also, through technology and the opening of global markets, these ETF Portfolios, which traditionally were accessible only to the High Net Worth markets, are now becoming more accessible to the broader market. This makes the concept of “Private Wealth” type of money management a more realistic goal for many in the mid income markets.

Is an ETF the right option for you?

As stated many times in previous articles, there is no ‘one size fits all’ solution for everybody. ETFs can be a great tool or strategy to use within an investor’s portfolio. However, as with other investments, if they are used they should be done so in a knowledgeable fashion. I would say, for individual investors who do their own trading, ETFs would be 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 or currencies, since they tend to be more risky. However, if using ETF Based Portfolios, investors can benefit from all the features ETF’s offer, along with the Professional Management of a qualified Portfolio Manager.

 

Although individual ETFs or ETF Portfolios can be a great addition to an overall investment portfolio, it’s always wise to consult with a qualified Financial Advisor before making a decision or implementation. Just as many other investments, there are multiple options or strategies available to use, and each should be analyzed carefully. Working alongside an Elite level Financial Advisor will enable you to make the best decisions as to if and how ETFs might fit into your overall Investment Plan.