The growing popularity of exchange-traded funds (ETFs) seems to have no end in sight. Even during 2022, which was a tough year for the markets, Canadian ETFs attracted an extra $35 billion in inflows.1 Canadian investors seemingly can’t get enough of this flexible, low-cost, high-diversification option.
If you’ve ever wondered, what is an ETF, this article is designed to help. We’ll answer some of the most common ETF-related questions, such as: what are ETFs, how do ETFs work, why are ETFs so popular, and why invest in ETFs?
What is an ETF?
ETFs are similar to traditional mutual funds, in that they’re pooled investment funds. This means that money from a large group of individual investors is merged and invested, according to the fund’s strategy.
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 how they can bring greater diversification to portfolios; some ETFs can hold stocks or bonds of hundreds of companies or issuers.
What is an issuer?
Issuers are companies, investment trusts or governments that develop, register and sell securities, such as stocks and bonds.
It can be a cheaper and more efficient way of diversifying than by buying lots of individual shares in companies.
What is an ETF strategy?
There are actually several ETF strategies; let’s start with index replication. An index is a theoretical portfolio of securities that is created and calculated by private companies, such as S&P, MSCI, Bloomberg and Solactive.
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 does an index ETF work?
Let’s say an individual investor wants to gain exposure to the S&P 500 (which tracks stocks from 500 of the largest companies on US stock exchanges). To mimic this exposure without buying an ETF or a mutual fund, investors would have to buy each stock in the exact proportion tracked by the index (the current lowest weight is 0.00004523%, which is not really very practical).
The cost of doing this by yourself would be around $22,107, even if you could buy 0.000002 fractional shares and invest as low as $0.01 in individual stocks. Additionally, you’d be paying about $2,500 in trading commissions, depending on the trading platform.
Even if the minimum investment in any single stock were $1 (which is still not realistic) then you’d need to invest about $2.21 million. If you weren’t able to buy fractional shares, the cost of buying each stock in the proportion of the S&P 500 would be over $10 billion.2 This goes some way to explaining ETFs’ popularity: they provide a very low-cost, simple way to gain broad diversification.
What is an ETF provider and what do they do?
ETF providers do a whole lot behind the scenes that individual investors would struggle to do by themselves, including:
- Managing cash flows (dividends) and potentially reinvesting them.
- Adjusting the portfolio to rebalance in line with the underlying index.
- Buying the necessary proportion of stocks included in the index and selling those that leave the index.
- Accessing 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 (QUU), 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 minimum effort and cost. Those low management fees allow potential returns to be fully realized.
Take the example of the Mackenzie Balanced Allocation ETF (MBAL): it provides 60% equities, 40% fixed income exposure, with Canadian, 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 types of ETFs
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’ve 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.
Read more about the different types of ETFs.
How to buy ETFs
If you’re interested in investing in ETFs, you can buy them through your financial advisor.
If you don’t have an advisor, you would need to open a brokerage account, such as a Tax-Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP), through a broker or an online trading platform. These accounts would then hold your ETFs.
ETFs can be bought from stock exchanges at any point during the trading day (unlike mutual funds, which can only transact at the end of the trading day). An ETF’s price is not simply a function of supply and demand; it is the aggregated price of the underlying stocks or bonds it holds. Also, unlike with traditional mutual funds, there is no minimum amount of time that you must hold onto an ETF.
Why invest in ETFs?
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 replicate an index’s performance, 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.
2 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.
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