The ETF advantage

Imagine an investment that provides many of the advantages of mutual funds—but it’s easier to buy and sell, and it has lower fees too. If that sounds good, then it’s time to meet one of the hottest investment products out there: the exchange-traded fund, or ETF.

Since the first one hit the market 20 years ago, these nimble investment funds have taken investors by storm. In late 2010, ETF assets reached $1 trillion (U.S.) and there are more than 915 different ETFs to choose from in North America.

Easy trader
If you’ve ever invested in mutual funds, you’re well aware of their advantages. Rather than dealing with a broker or choosing stocks to invest in on your own, you can buy one mutual fund and let a professional money manager put together a diversified portfolio of stocks or bonds for you.

But while mutual funds can be a great way to start investing, they also have some drawbacks. Buying or selling a mutual fund can take several days. The fees can be high, and while fund managers can add value, they don’t always make good stock picks.

ETFs offer a quicker way to buy and sell funds. When you buy an ETF, as with a mutual fund, you get an instant portfolio of dozens, even hundreds, of stocks or bonds. But instead of buying the fund through an adviser and waiting several days for the transaction to take place, you can buy an ETF instantly on the market, just like a stock—they even have ticker symbols.

Traditional ETFs also differ from mutual funds in that their managers do not choose the individual stocks or bonds in an attempt to beat the market. Instead, they follow indexes, usually created by third parties, that are designed to give investors the returns of overall markets. This means you can’t underperform a market by much, and it helps keep the cost of ETFs low.

Evolution of a market marvel
The world’s first successful ETFs were launched by the Toronto Stock Exchange back in 1990. Originally called Toronto Index Participation Shares, they tracked the TSE 35 index (and later the TSE 100). The success of the participation shares prompted two executives from the American Stock Exchange, Nathan Most and Steven Bloom, to develop a similar investment product for the American market called Standard & Poor’s Depositary Receipts, or SPDRs (pronounced “spiders”) for short. This ETF, which still trades with the ticker symbol SPY, tracks the S&P 500 index of large U.S. companies.

Both the Canadian and American ETF products were created to allow investors to easily get the same return as the indexes they tracked. For instance, if an investor bought the SPY ETF, she would get the same performance (before fees) as she would get if she took her money and split it up among each of the 500 stocks that make up the S&P 500 index (as long as she weighted her investments the same as the index does). The aim was to create a simple investment that could easily give you performance similar to that of an entire market.

Low, low fees
With a mutual fund, you have to pay your fund manager to choose the individual stocks that go in your fund. But ETFs don’t have fund managers because they automatically include the same stocks with the same weighting as their underlying index. Because ETF providers don’t have to do stock-picking research and analysis, the fees for ETFs tend to be lower. For instance, the annual fee for the ETF that follows the main index in Canada (the S&P/TSX Composite Index), is about one quarter of one percent. Typical equity mutual fund fees, on the other hand, tend to fall somewhere between 2% and 3%.

“Mutual funds have to issue quarterly statements, annual prospectus reports and issue proxies and circulars,” explains Richard Ferri, CEO of Portfolio Solutions, and author of The ETF Book. “On top of that, they need to educate brokers and keep their administrative side up to date and all this takes money. ETFs, on the other hand, are more cost-effective. That’s translated into lower management fees.”

How do you buy ETFs?
That’s not to say there are no fees at all with ETFs, of course. In addition to paying a fee to cover operating expenses (known as the management expense ratio or MER), whenever you buy or sell an ETF, you have to pay a commission, just like you do when you buy or sell an individual stock.

The most cost-efficient way to buy and sell ETFs is through a discount brokerage. These allow you to set up online accounts where you can buy and sell stocks, bonds, mutual funds and ETFs yourself without having a broker do it for you. There is no one to provide advice on what to buy or sell, but the trading fees are much lower. All the big banks have discount brokerage arms, and there are a few independents too (see How to open a discount brokerage account ).

The cost of buying and selling ETFs is typically between $5 and $29 a trade, depending on your brokerage, the amount of money you have in your account, and how frequently you trade. After you buy, your ETFs rise and fall in value along with the index they follow. You make money if you sell your ETF for more than you bought it for, and you lose money if you have to sell it for less. Some ETFs pay you regular dividend income as well.

Tax-efficient, too
The final reason many investors like ETFs is because they are tax-efficient. Whenever a fund sells stocks or bonds at a profit, it generates capital gains, and these gains usually mean a higher tax bill for investors.

ETFs tend to have a lower turnover than mutual funds, because they hold on to their stocks for as long as the companies remain in the index. They also use an innovative structure that allows them to avoid having to sell the underlying securities whenever investors redeem units in the ETF. “This makes the ETF basket much more tax-efficient than a mutual fund,” says Ferri. In fact, many ETFs have managed to entirely avoid passing on taxable capital gains to their investors.

Today there are hundreds of ETFs following every imaginable sector in the stock and bond markets. There are ETFs following commodities, precious metals and currencies. ETFs now follow different types of index structures, some have leverage built in, and some don’t even directly buy the stocks they follow. In May, look for the next booklet in our four-part series on ETFs, where we’ll take a closer look at how to trade ETFs effectively.

Frequently asked ETF questions

Where can I buy ETFs?
You can buy ETFs through a stock exchange, such as the TSX. They can be bought or sold any time the market is open. Many people use a discount brokerage account to buy and sell them.

How do I make money with an ETF?
The price of your units goes up if the index your ETF follows rises. So if you bought an ETF that follows the S&P/ TSX Composite, and the Canadian market went up, the price of your ETF would rise too. As with a stock, if you sell your ETF for a higher price than you paid, you make a profit. If you sell for less than you bought it for, you suffer a loss. Some ETFs hold dividend-paying stocks and pay you regular distributions too.

What’s the most common type of ETF?
The most common type of ETF is a broad-market ETF. These ETFs follow the big market indexes, such as the S&P/TSX Composite index in Canada or the S&P 500 in the U.S. There are many other types of ETFs though, including sector, industry, countryspecific, commodity, currency, leveraged, short and actively managed ETFs.

Are ETFs good for retirement portfolios?
ETFs can be used in your retirement portfolio as part of a buy-and-hold strategy, where the same ETFs may be held for decades. An investor would typically build a diversified portfolio of broad-market ETFs and rebalance them just once a year.

What else can I use ETFs for?
ETFs can be used for day trading, currency speculation, commodity trading—almost any kind of investing you can think of. They can be a very low-risk way to invest, but they can also be riskier than investing in individual stocks. It all depends on how you use them.