ETFs’ growing popularity seems to have no end in sight. Canadian ETFs currently hold almost $320 billion in assets, a 36.2% annual increase1. Canadian investors seemingly can’t get enough of this flexible, low-cost, high-diversification option.
If you’re not sure exactly what ETFs are, this blog is designed to help. We’ll answer some popular ETF-related questions, such as what are ETFs, how do they work, why are ETFs so popular, and why should you care?
Exchange-traded funds: a definition
ETFs, or exchange-traded funds, are pooled investment funds. This means that money from a large range of individual investors is merged and invested to follow the fund’s predetermined strategy. In this sense, ETFs are similar to mutual funds.
When investors pour money into an ETF, the ETF provider invests it in a range of securities (such as stocks or bonds, etc.). A key advantage of ETFs is to bring greater diversification to portfolios: some ETFs can hold stocks or bonds of hundreds of companies or issuers.
It is a far cheaper and more efficient way of diversifying than by buying lots of individual shares in companies.
What are issuers?
Issuers are companies, investment trusts or governments that develop, register and sell securities, such as stocks and bonds.
An example of ETF strategies
Let’s start with a common ETF strategy: index replication. An index is a theoretical portfolio of securities that is created and calculated by private companies, such as S&P, MSCI, Bloomberg, Solactive, etc.
Each one has its own definition of how to best represent the market they are trying to replicate (for example, the S&P 500, the MSCI USA and Solactive’s US Large Cap Index all try and replicate the largest US companies’ performance). Indices can look very similar, but the way the index is built, maintained and rebalanced can bring very different results (read “Index ETFs are not all created equal” for more details).
The ETF provider (such as Mackenzie) tries to replicate the index with as little deviation as possible between the ETF that you can buy and the theoretical index, which you can’t actually buy. This is measured by tracking difference and tracking error: the lower they are, the closer the fund matches the index.
How an index ETF works
Let’s say an individual investor wants to gain exposure to the S&P 500 (which tracks stocks from some of the largest companies on US stock exchanges). To mimic this exposure without buying an ETF or mutual fund, investors would have to buy each stock in the exact proportion tracked by the index (the current lowest weight is 0.00004523%; not really something that’s doable).
The cost of doing this by yourself would be around $22,107, IF you could buy 0.000002 fractional shares and invest as low as 0.01$ in each name. Additionally, you’d be paying about $2500 in trading commissions depending on the trading platform. IF the minimum investment in any single stock is $1 (which is still not realistic) then you need about $2.21 million. IF you couldn’t buy fractional shares, the cost of buying each stock in the proportion of the S&P 500 would be north of $10 billion.* This goes some way to explaining ETFs’ popularity: they provide a very low-cost, simple way to gain broad diversification.
What ETF providers do
ETF providers do a whole lot behind the scenes that individual investors would struggle to do by themselves:
- Manage cash flows (dividends) and potentially reinvest them
- Adjust the portfolio to rebalance in line with the underlying index
- Buy the necessary proportion of stocks included in the index and sell those that leave the index
- Access foreign assets (stocks and bonds) at institutional rates
There are fees with every transaction, so it would be very expensive for individual investors to manage this by themselves, and the ultimate performance would probably be nowhere near that of the index.
This process can get even more complicated when you want to replicate international or fixed income indices. The alternative is buying an ETF, such as the Mackenzie US Large Cap Equity Index ETF, which will take care of all of this for a management fee of only 0.06%. It’s not surprising ETFs are so popular with both individual and institutional investors.
An ETF gives you instant access to hundreds or even thousands of stocks or bonds, domestic or foreign, for a minimum of effort and cost. Those low management fees allow potential returns to be fully realized.
Take the example of the Mackenzie Balanced Allocation ETF: it provides 60% equities, 40% fixed income exposure, with Canada, US, international and emerging market stocks and bonds. There are over 4,200 underlying assets, rebalanced and maintained for a fee of just 0.17%.
Different ETF strategies
Many ETFs go further than simply replicating an index. ETFs can now provide investors with access to a variety of different investment strategies. In recent years, they have increasingly offered access to strategies designed to outperform indices.
Thematic ETFs also allow you to invest in specific market segments, such as green bonds, infrastructure and real estate.
How do you buy and sell ETFs?
ETFs are bought and sold on stock exchanges, but unlike with common stocks, their price is not simply a function of supply and demand. The price of an ETF is the aggregated price of the underlying stocks or bonds it holds. You can buy and sell ETFs at any point during the trading day (unlike mutual funds, which can only transact at the end of the trading day). Also, unlike with mutual funds, there is no minimum amount of time that you must hold onto an ETF.
Why should you care?
ETFs provide an efficient way to increase diversification in your portfolio, whether it’s in terms of geography or types of assets, and usually for a very low fee. They aim to bring you the performance of an index, or possibly even deliver a superior performance. This is even more impressive when you realize how difficult and expensive it would be to do this on your own.
Talk to your financial advisor to find out more about ETFs and how they could fit into your portfolio.
1 Source: Investor Economics and the Investment Funds Institute of Canada (IFIC)
* Based on Bloomberg Data, As of October 14, 2021.
Commissions, management fees, brokerage fees and expenses all may be associated with Exchange Traded Funds. Please read the prospectus before investing. Exchange Traded Funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the prospectus before investing. The content of this article (including facts, views, opinions, recommendations, descriptions of or references to, products or securities) is not to be used or construed as investment advice, as an offer to sell or the solicitation of an offer to buy, or an endorsement, recommendation or sponsorship of any entity or security cited. Although we endeavour to ensure its accuracy and completeness, we assume no responsibility for any reliance upon it. This document may contain forward-looking information which reflect our or third party current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties and assumptions that could cause actual results to differ materially from those expressed herein. These risks, uncertainties and assumptions include, without limitation, general economic, political and market factors, interest and foreign exchange rates, the volatility of equity and capital markets, business competition, technological change, changes in government regulations, changes in tax laws, unexpected judicial or regulatory proceedings and catastrophic events. Please consider these and other factors carefully and not place undue reliance on forward-looking information. The forward-looking information contained herein is current only as of October 19, 2021. There should be no expectation that such information will in all circumstances be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise. This should not be construed to be legal or tax advice, as each client’s situation is different. Please consult your own legal and tax advisor.