What Is An ETF: Understanding How ETFs Work In Canada
Exchange-traded funds, commonly known as ETFs, have become increasingly popular for investors seeking a simple and efficient way to diversify their portfolios. ETFs are a crucial component of a passive investment strategy, focusing on long-term growth and minimizing fees and taxes.
But what are ETFs, how do they work, and where can you invest in ETFs in Canada? I’ll answer those questions and more in this article.
Most ETFs are designed to track a specific market index, which is why they typically offer lower costs than actively managed mutual funds. Investors who choose ETFs can benefit from broad exposure to the stock market while keeping their costs lower than if they were investing in many individual securities. ETFs are part of an passive investment strategy, focusing on long-term growth and minimizing fees.
What Is An ETF?
An exchange-traded fund (ETF) is an investment fund that allows you to buy a large basket of individual stocks, bonds, commodities, or other assets in one purchase. It’s a diversified investment vehicle that helps you spread your investments across a wide range of underlying securities.
The beauty of ETFs is that they can be bought and sold during regular market hours, just like individual stocks, making them a popular choice for Canadian investors.
When you invest in a broad market index ETF, you’re buying a share of a portfolio designed to track the performance of a specific index or investment theme. This means that your returns will often closely mirror those of the underlying assets, giving you a passive investment approach while still providing growth potential.
Some index ETFs focus on the Canadian economy, while others offer exposure to international markets or specific sectors, such as technology or green energy.
Like any investment, ETFs also come with their own set of risks. However, diversification can reduce some of these risks.
Active vs. Passive Management
Historically, ETFs have been considered passive investments, but nowadays, many investment firms are introducing ETFs with an actively-managed component.
Actively managed ETFs try to outperform the market by employing a team of expert portfolio managers who select specific securities and adjust the fund’s holdings based on market conditions. The strategy can result in higher returns, but there is an added cost in the form of higher management fees.
On the other hand, Passively Managed ETFs aim to track the performance of a specific market index, like the S&P/TSX Composite Index in Canada or the S&P 500 in the US. These ETFs generally don’t try to outperform the market; instead, they replicate the composition of the underlying index.
As a result, passively managed ETFs typically have lower fees than their actively managed counterparts since they don’t require the same level of ongoing management.
If you’re willing to pay higher fees for the potential of higher returns and have confidence in portfolio managers’ skills, actively managed ETFs might be a suitable choice. However, passively managed ETFs will be better if you prefer a less hands-on approach and want lower management fees.
ETFs vs. Mutual Funds
Many investors wonder how ETFs differ from mutual funds, as they have some things in common. Both are mixed investments managed by fund managers. They also charge fees, called management expense ratios (MERs), which cover the fund’s costs. And the prices at which mutual funds and ETFs are traded are determined by their net asset value (NAV).
But ETFs and mutual funds also have some key differences.
Unlike mutual funds, ETFs trade on the stock exchange and can be bought and sold throughout the trading day, just like individual stocks. Mutual funds, on the other hand, are purchased and sold through an investment or mutual fund dealer at the end of each trading day.
Most ETFs are passively managed, which means they track the performance of an index or a specific basket of assets. Mutual funds are often actively managed by analysts and fund managers who aim to outperform the market. As I mentioned, actively managed mutual funds tend to have higher expense ratios due to the costs associated with this management style.
When placing orders, ETF investors need to have a brokerage account and can use different types of orders like limit, stop-limit, or short-sale. Mutual fund investing does not require a brokerage account, and investors can transact directly with the mutual fund company. You cannot buy mutual funds on margin or set specific order types like with ETFs.
Types Of ETFs
Exchange-traded funds can be grouped into several categories, some of which are listed below:
Index ETFs aim to replicate the performance of a particular market index, like the S&P 500 or the TSX Composite Index. They offer broad-market exposure by investing in a single, low-cost fund.
Sector ETFs, or industry ETFs, allow you to invest in specific industries like technology, healthcare, or energy. Investing in a sector ETF exposes you to a group of companies within that industry, helping you capitalize on emerging trends and growth opportunities. This strategy can be beneficial if you believe a specific sector is poised to outperform the broader market.
Fixed Income ETFs
Fixed Income ETFs invest in bonds and other debt securities, including government and corporate bonds. These ETFs can provide regular income and stability to your investment portfolio, making them an attractive option for conservative investors or those looking to diversify beyond stocks.
Thematic ETFs focus on particular investment themes or trends, such as environmental, social, and governance (ESG) investing, robotics, artificial intelligence, or clean energy. By investing in a thematic ETF, you can gain targeted exposure to innovative companies and industries shaping the future. Remember that thematic ETFs are often more volatile than broader-index ETFs because they concentrate on specific market segments.
ETFs can also be classified into other categories, including international ETFs, diversification ETFs, leveraged ETFs, commodity ETFs, currency ETFs, specialty ETFs, emerging markets ETFs, and equity ETFs.
Where to Buy ETFs in Canada
To buy ETFs in Canada, you need to open a brokerage account. There are at least a dozen online brokers, but some are better for ETF trading than others, namely Questrade and Wealthsimple Trade. I like both platforms because, unlike most Canadian brokers, they offer free ETF purchases.
Questrade is a large independent brokerage known for its low fees and ease of use. It offers a variety of account types, both registered and non-registered. You can buy ETFs without paying any commissions. However, when you sell them, there’ll be a fee between $4.95 and $9.95, depending on the trade size. You can read our full Questrade review here.
Wealthsimple Trade is designed for investors seeking a simple, commission-free trading experience. The user-friendly app and desktop platform make it easy to manage your ETF investments from your smartphone. There are no trading fees when you buy or sell ETFs with Wealthsimple Trade. Learn more in our Wealthsimple Trade review.
ETFs can help you build a diversified portfolio that’s tailored to your unique financial goals. And their low-cost nature is an added benefit that can save you thousands of dollars in fees, leading to better overall returns in the long run.
If you’re trying to decide between ETFs and mutual funds, also remember that ETFs are easily bought and sold on the stock market during normal trading hours and can cater to various investing styles and risk tolerances.
What are the top ETFs?
While this article isn’t about the best ETFs, you can research exchange-traded funds based on criteria like past performance, capitalization size, historical dividends, and industry focus. Remember that past performance doesn’t guarantee future results, and diversifying your investment portfolio is always a good idea.
What is the difference between ETFs and stocks?
Stocks represent shares in a single company, whereas ETFs are a collection of different investments, such as stocks, bonds, or commodities. When you purchase a share of an ETF, you’re investing in a basket of assets, which can help you diversify your portfolio and spread the risk across multiple sectors or industries.
Are ETFs suitable for long-term investment?
ETFs offer diversification, which can help reduce the overall risk in a long-term investment portfolio. They also tend to have lower management fees than mutual funds, making them a cost-effective option for long-term investors. Before investing, consult with an investment professional to determine if ETFs suit your portfolio.