What's an ETF?

Want to start investing but feeling a bit overwhelmed by your options? We understand.

From mutual funds and bonds to stocks and REITs, figuring out precisely what to invest your hard-earned money in isn’t always easy.

To get you started, we’ve put together this guide to one of the most popular investment options on the market today: the ETF (Exchange Traded Fund).

In this article, we’ll discuss what an ETF is and how it works. We’ll also give you some insight into the advantages and disadvantages of investing in ETFs so you can decide if they’re the right option for your needs.

What is an ETF?

One of the most popular investment options on the market today, an ETF or exchange-traded fund, is a great choice for passive investors who are looking for lower-risk investment options.

Now you may be wondering if it’s the right investment option for you, so let’s start by breaking down what an ETF is, how it works, and the advantages and disadvantages of investing in ETFs, so you can decide if they’re the right option for your needs.

An ETF, or exchange-traded fund, is a type of investment vehicle that bundles multiple assets together so they can be traded as a single product on a financial market.

Sounds like a bunch of jargon? Let’s simplify it further: first and foremost, an investment vehicle is anything that you might choose to invest in, be that bonds, stocks, or even fine art. An ETF is just another type.

What makes ETFs special, however, is that they are a collection of different assets that are traded together as one unit. Shares of ETFs can be bought and sold by investors on a financial market, like the Toronto Stock Exchange (TSX), throughout the trading day.

How do ETFs work?

Depending on the type of ETF you invest in, those assets could include shares of stocks, bonds, commodities, or even other ETFs.

To establish an ETF, the fund’s provider (normally a financial institution like Vanguard) purchases all of the assets that they want to include in the fund. The type of assets included in the fund will largely depend on the goal of the investment and can range anywhere from Canadian-listed stocks to foreign bonds.

Regardless of what’s in the ETF, however, the fund’s provider will then bundle these assets together, get a ticker symbol for the fund, and then list it on an exchange, like the TSX.

At this point, individual investors, such as yourself, can buy and sell shares of the fund during the trading day, just like you would with a stock. As with stocks, when an ETF’s trading price goes up, so does the value of your investment, and vice-versa.

ETFs aren’t free. In order to pay for the management of the fund, the majority of ETFs charge what’s known as an expense ratio.

This ratio is expressed as a percentage and it tells you how much you’ll pay in fees per year. For example, an expense ratio of 0.08% will cost you $0.80 in fees per $1,000 invested in a fund.

The good news is that ETF fees tend to be relatively low (at least when compared to mutual funds). They’re also automatically deducted from your earnings, so you won’t have to pay for them out of pocket.

ETF vs Stocks vs Mutual Funds

There are definitely similarities between the three types of investment options. Let’s start by looking at what stocks and ETFs have in common. Like stocks, they can be bought and sold on the market throughout the day. Both have a ticker symbol and are subject to price fluctuations. However, unlike a stock, which is a standalone entity, ETFs are made up of individual stocks and other investments. That’s why when it comes to diversification of our portfolio, ETFs offer you more exposure and can help reduce your risk.

Now, let’s look at similarities and differences between ETFs and mutual funds.

Both are great for diversification as both are in essence, groups of individual assets like stocks, bonds, and commodities. However, mutual funds that can be traded only once a day, ETFs can be traded throughout the day on the market and they experience price fluctuations all day long.

Types of ETF

While some ETFs seek to track a market index, some funds are designed with specific themes in mind. These themes can vary widely from fund to fund, and they’re a great way to expose your portfolio to a specific type of investing. Some of the most popular ETF types you might encounter include:

• Sector and Industry ETFs: Sector-based ETFs are some of the most common thematic-based funds. These funds invest in a specific industry, like healthcare, information technology, or aeronautics.

• ESG ETFs: ESG (environmental, social, and governance) ETFs are all about investing in companies and industries that promote ethical business practices.

• Index ETFs: Index ETFs can include a wide range of securities like stocks, bonds, commodities and track a particular index such as NASDAQ.

• Commodity ETFs: As a part of commodity ETFs, investors can choose to bundle and buy specific commodities like gold, corn, crude oil, etc.

• Currency ETFs: Currency ETFs are bundles of either individual currencies or different currencies from a particular region, and can track both foreign and domestic currencies.

• Bond ETFs: Bond ETFs generate regular payments for the investor because they don’t come with a fixed maturity date like bond investments do. They can be bundles of government bonds or corporate bonds or local municipal bonds.

"An ETF, or exchange-traded fund, is a type of investment vehicle that bundles multiple assets together so they can be traded as a single product on a financial market."

Advantages of ETFs

• When compared to other similar investment products, like stocks and mutual funds, ETFs offer a number of key advantages. Some of the primary benefits of ETFs include:

• Lower expense ratios than mutual funds

• Higher liquidity

• Thousands of options to choose from

• Diversification

• Easy to buy and sell throughout market open hours

• Purchase price starts at the cost of a single share

Disadvantages of ETFs

When compared to investing directly in stocks, bonds, and commodities, the primary disadvantage of investing in ETFs is that you don’t get to make any day-to-day decisions about what the fund invests in. In that sense, ETF investment is primarily a passive form of investment, and may not make sense for those who actively monitor the market and like to make quick decisions. Although relatively uncommon, this means that a fund manager could completely misread the market at any given moment.

For many investors, this lack of autonomy is actually an advantage because it frees you from having to do in-depth market analysis. But for active investors who would rather hand-pick their stocks, bonds, and other securities, ETFs aren’t always the best choice.

How do I invest in ETFs?

1. Investing in ETFs is a multi-step process, but it’s fairly straightforward. Here’s how it works:

2. Open a brokerage account. The vast majority of people who invest in ETFs do so with an online brokerage. Many also offer $0 trades on ETFs, so you can save money as you invest.

3. Research your future ETFs. The sheer number of ETF options available on the market can be a double-edged sword. On one hand it gives you the choice to diversify but on the other hand, it can feel overwhelming. So start by narrowing down your options by using filters such as risk tolerance, cost, and liquidity.

4. Place a buy order. Once you find the ETFs you want to invest in, you’ll place a trade to buy shares of that ETF through your online brokerage.

5. Monitor your profile. After you buy your ETFs, it’s time to start monitoring your profile. Most folks plan to hold their ETF investments for at least a few years before selling in the hopes of turning a profit.

This is the process for managing your own ETF investments. However, there are robo-advisors you can use that automate the process. The only thing you need to do is sign up, choose your risk tolerance, and leave the buying and selling the robo-advisor.

Are ETFs a good investment?

ETFs are a popular investment product, so you’ll see them in the vast majority of investors’ portfolios. They offer a number of benefits when compared to mutual funds and stocks, which makes them a nice choice for both active and passive investors.

However, the key to investing is to find various investment vehicles that meet your unique financial goals. If you’re the type of person that wants a relatively simple, highly liquid, and fairly low-cost investment tool, ETFs might be a good choice. But if you are someone who likes to actively change your investment strategy and portfolio based on market trends, ETFs might not make sense for you.