As you seek to expand your portfolio, it’s important to thoroughly understand the different options available. Take exchange-traded funds (ETFs), for instance.
While many consider them very similar to mutual funds, ETF trading dynamics are far more fast-paced. By incorporating these into your existing investment methodology, you can give yourself a versatile edge.
So, what is an ETF in Canada, and should you include them in your investment portfolio?
Key Points
| ETF Stands For | Exchange-traded fund (ETF) |
| What is it? | An ETF is a collection of securities that trades on major exchanges like stocks. |
| Purpose Of ETFs | ETFs allow investors to invest in several securities at a time and can be traded throughout the trading day. |
| Liquidity Level | Most ETFs have high liquidity, which means they can be easily bought and sold. |
| Risk Level | ETFs are typically highly diversified. |
What Is An ETF In Canada?
An exchange-traded fund is a basket of multiple assets, similar to mutual funds. By compiling different assets into the fund, you get the benefits of diversity and the safeguards it offers by spreading out your risk. ETFs trade on stock exchanges, much like regular stocks, making them easy to buy and sell throughout the trading day.
How Do ETFs Work?
The unique approach of exchange-traded funds is that they can be traded throughout the day. Similar to stocks, these funds can undergo multiple trades in a short period of time.
ETFs work by pooling funds from several investors to buy a diversified basket of securities. ETF funds are managed either passively or actively. A passively managed fund involves tracking an index, such as the S&P 500, and an actively managed fund involves a manager making trading decisions to beat the market.
ETFs have two prices: the market price, which is the price at which you trade them, and the net asset value (NAV), which represents the true value of the ETF’s underlying assets.
While these prices can vary slightly due to supply and demand, the difference is typically minimal thanks to a process called “creation and redemption in kind.”
In this process, ETF issuers work with specialized firms called authorized participants, who monitor and adjust the supply of ETF shares by trading the underlying assets.
This mechanism helps keep the market price and NAV closely aligned, making trading more seamless for everyday investors.
Features Of ETFs
Key features of ETFs include the following:
- Diversification. ETFs often track indexes, such as the S&P 500. This allows investors to be exposed to various assets in just one fund.
- Liquidity. ETFs are traded on major stock exchanges, as mentioned. As such, they can be easily purchased and sold, giving investors plenty of flexibility.
- Variety. ETFs are highly varied for different asset classes and sectors. These include stocks, bonds, and commodities, among others.
- Tax Advantages. The passive management nature of ETFs typically means they have fewer capital gains, which can translate to fewer taxes paid.
- Lower Fees. Generally speaking, ETFs come with lower fees than mutual funds because they’re typically managed passively.
Types of ETFs In Canada
There are several kinds of ETFs, each separated primarily by the nature of the investment. Such types include:
Stock ETFs
Stock ETFs track the performance of a specific index, like the S&P 500. They may also track a particular sector, such as energy or technology. Stock ETFs are attractive to growth investors because they offer exposure to a range of individual stocks without having to buy them separately.
Bond ETFs
Bond ETFs provide exposure to a variety of bonds issued by governments or corporations, spanning different maturities and geographies. These funds pay income, often monthly, making them attractive to income-focused investors. While less risky than stocks, bond ETFs still provide moderate growth potential, especially when diversified across different types of bonds.
Currency ETFs
Currency ETFs track the performance of one currency, like the US dollar or euro, or a basket of several currencies. This type of ETF uses the balance of the currency exchange market to achieve desired results.
Commodity ETFs
Commodity ETFs provide investors with exposure to physical commodities, such as gold, silver, or oil. These ETFs may track futures contracts or be backed by actual commodities.
Sector / Industry ETFs
Similar to a commodity ETF, those whose assets are placed into a specific industry fall into this category. Within this spectrum, there are a lot of different methods of practice. Examples of the industries include air travel, the banking sector, and technology. By addressing an entire market sector, the investment has a good chance of success provided that the arena remains reasonably stable.
Inverse ETFs
This type of ETF became popular after the 2008 market crash. This is largely because those with this type of investment saw the biggest profit out of the incident. These ETFs practice something referred to as ‘shorting’. This means the stock is sold when the price decreases. When the price gets low enough, the fund purchases back the stock for a reduced price.
Leveraged ETFs
Leveraged ETFs aim to deliver 2x or even 3x the returns of an underlying index, such as the S&P 500, in a single day. These ETFs are designed for short-term trading rather than long-term holding, as the compounding effect can lead to significant deviations from the expected return over time.
Cryptocurrency ETFs
Cryptocurrency ETFs hold digital assets like Bitcoin or Ethereum, giving investors exposure to these cryptocurrencies without needing a digital wallet. These ETFs are relatively new and can be highly volatile, attracting investors interested in exploring the high-risk, high-reward potential of cryptocurrency markets.
Money Market ETFs
Money Market ETFs invest in short-term, high-quality debt securities, such as Treasury bills or commercial paper. These funds are relatively stable, maintaining a fairly consistent share price and paying out monthly interest based on prevailing rates. Money market ETFs are popular with conservative investors looking for liquidity and minimal price fluctuation.
Socially Responsible ETFs
Socially responsible ETFs involve investments in companies that meet specific ethical or environmental criteria, such as social responsibility or sustainability.
Differences Between ETFs And Mutual Funds
There are some key differences between ETFs and mutual funds:
| ETFs | Mutual Funds | |
| Time Of Trade | All throughout the day | At the end of the trading day |
| Management | Usually passively managed, but may be actively managed | Actively or passively managed |
| Liquidity | High liquidity | Lower liquidity |
| Costs | Lower fees & commission costs | Higher fees |
| Tax Benefits | More tax-efficient | Less tax-efficient |
| Minimum Investment | No minimum | Small minimum required, typically at least $500 |
Time Of Trade
ETFs can be traded throughout the day based on small changes in the market index. Mutual funds can only be traded at the end of the business day. At this time, the value of the mutual fund is declared, and it sets a price for the exchange.
Management
Typically, the management of mutual funds is approached in an active way. This means that there is a professional who is responsible for choosing the investments based on analysis.
Conversely, an ETF setup uses a passive approach to the overall structuring. This means that the investment locations largely depend on the market and a more algorithmic focus on the index. Requiring much less attention than mutual funds, there is also less customization associated with the structure.
Liquidity
ETFs are more liquid than mutual funds. This is mainly because ETFs can be bought and sold like stocks on stock exchanges all throughout the trading day. On the other hand, mutual funds are bought and sold directly with the fund at the closing of the trading day.
Costs
ETFs typically have lower fees than mutual funds. While ETFs are often managed passively, mutual funds are actively managed.
Tax Benefits
ETFs often have fewer taxable events than mutual funds, such as capital gains distributions, thanks to the creation/redemption in-kind mechanism. As such, ETFs are more tax-efficient than mutual funds.
Minimum Investment
Most mutual funds require a minimum upfront investment, typically at least $500 and up, though some mutual funds require no minimums. On the other hand, ETFs require no minimum investment amounts other than the price of a single share, or less if your brokerage has fractional trading enabled.
Pros And Cons Of ETFs
As with anything else in the finance sector, investing in an ETF has benefits and drawbacks. By considering them all, and assessing your financial priorities, you can make the best judgment call for your investment activity.
Pros Of ETFs
The following are some of the perks of investing in ETFs:
- High Liquidity. Since ETFs trade on stock exchanges and can be bought and sold at any point during the trading day, they’re highly liquid. This provides multiple trading opportunities throughout the day and lots of flexibility for investors.
- Wide Selection. Investors of ETFs have access to various asset classes, including stocks, bonds, equities, commodities, and sectors.
- Cost-Effective. ETFs typically come with lower fees and expense ratios compared to mutual funds, making them an affordable investment vehicle for investors. That means investors can keep more of their returns.
- Lower Risk. ETFs allow investors to get exposed to a wide range of assets within a single fund. This helps hedge against potential risk compared to investing in one stock.
- Tax Efficient. Since ETFs are subject to fewer taxable events than mutual funds, they’re relatively tax-efficient.
Cons Of ETFs
Be sure to consider some of the drawbacks of investing in ETFs:
- Potentially High Trading Costs. Since ETFs can be bought and sold at all times of the trading day, there’s the possibility of frequent trades. This can lead to higher transaction costs, particularly for those who trade often.
- Possible Concerns With Spreads. For some ETFs, the bid-ask spread can increase trading costs, especially those that are not traded often and during volatile markets.
- Dividends May Not Be Automatically Reinvested. Mutual funds typically reinvest dividends automatically. However, ETFs usually pay investors dividends in cash. Investors typically have to arrange to have their dividend payouts automatically reinvested.
- Overwhelming Choices. Because ETFs offer a wide range of options, it can be a bit overwhelming for investors, particularly novice investors. Picking the wrong ETF can lead to unnecessary losses and poor gains.
Where Can You Buy ETFs In Canada?
You can buy ETFs through various institutions and platforms, such as the following:
Financial Advisors
Financial advisors and full-service brokerages offer multiple investment services, including money management and financial consultation. If you’re looking to buy ETFs, your broker will execute the trade for you.
Online Brokerages
Online investment brokerages and robo-advisors have become very popular among Canadian investors. Popular platforms in Canada include Questrade and Wealthsimple Trade, which provide commission-free services to help keep investment costs low.
Banks
Your bank likely offers investment services that allow you to purchase and sell ETFs and other investment vehicles. Examples include BMO InvestorLine and Scotia iTRADE.
Retirement Accounts
You can purchase ETFs directly through your Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA).
Final Thoughts
ETFs are suitable for investors looking for low-risk, low-cost, diversified, and tax-efficient investments. However, they may not be ideal for active traders who make several trades per day. Becoming familiar with the perks and drawbacks of ETFs is important to make an informed decision with your investments.
