You’ve probably heard of ETFs if you’ve read anything about investing. ETFs, or exchange-traded funds, have become popular for investors seeking simple diversification without many costs. But what precisely are they, and how do they work?
What exactly is an ETF?
An ETF is essentially a collection of investments like stocks or bonds. In this regard, they are comparable to mutual funds, but unlike mutual funds, shares of ETFs can be exchanged on an exchange throughout the day, much like individual stocks.
The first exchange-traded funds (ETFs) were launched in the 1990s to provide individual investors with a simple, liquid way to invest in major market indexes such as the S&P 500. They’ve grown in popularity: there are over 2500 U.S.-based ETFs.
An individual ETF is a subset of assets, and specialized ETFs hold numerous investments that meet a specific profile, such as clean energy. In contrast, asset allocation ETFs can be viewed as “an instant portfolio of Canadian, U.S., and worldwide equities, plus bonds customized for a specific investing purpose.”
What are the advantages of ETFs?
ETFs provide three important benefits: diversification, cheaper costs, and ease.
Diversification
Many investors appreciate ETFs for their simplicity: they provide diversity at a reasonable cost. This is especially true for do-it-yourself investors who don’t want to commit their entire time to manage a complex portfolio. The goal is to be the market, not to beat it, argues Globe and Mail contributor Joel Schlesinger. History demonstrates that, after costs, actively managed portfolios – those in which professionals choose what to invest – do not outperform markets overall, he says.
Low costs
This brings us to the second benefit of ETFs over other financial tools: they often have cheap fees. Rob Carrick, a Globe contributor, prefers asset allocation ETFs, which provide a fully diversified portfolio in a single package. The cost of owning asset allocation ETFs is quite cheap, he adds, “and the cost of purchasing them ranges from nothing to just under $10 each purchase.”
Convenience
Because of their simplicity, asset allocation ETFs are a favorite of portfolio manager Dan Bortolotti. You simply purchase one item and continue to purchase it as it automatically rebalances itself. You don’t have to determine where to devote new money to your portfolio, Mr. Bortolotti explains. You simply purchase more shares of your sole ETF, preventing every contribution from becoming a market-timing choice.”
What types of ETFs are available?
Since the introduction of ETFs three decades ago, most of the capital has been invested in low-cost index funds that cover broad market segments. Despite the general trend of keeping fees as low as possible, ETF providers also release more specific active management and sophisticated strategies at higher rates.
Many experts advise investors to choose low-cost ETFs with extensive diversification as a straightforward, low-cost, and effective method. If you are an index investor, your largest determinant of success is to minimize the cost because every basis point you pay to acquire exposure to that index is going to work against you, says Mark Noble, executive vice president of ETF strategy at Horizons ETFs Management (Canada) Inc. (Basis points are one-hundredths of a percentage point.)
Specialized ETFs
There are a plethora of specialized ETFs covering just about anything under the sun. Crypto ETFs invest in individual cryptocurrencies like bitcoin or ether. Real estate investment trust ETFs hold shares in REITs from various industries, including housing and retail. Sustainability-focused ETFs enable investors to match their holdings with their principles by selecting funds that incorporate environmental, social, and governance aspects in their purchasing process, strive to make an impact on ESG-related issues or invest in a specific environmental sector such as water.
High-interest savings ETFs invest primarily in high-interest savings accounts and deposits from large banks, making them a convenient location to park capital.
What is the structure of ETF fees?
Fees on ETFs are calculated as a proportion of your holdings, and the management expense ratio is a good way to summarize this. The MER is the main ongoing expense of owning an ETF and varies based on the product. Mr. Carrick estimates that asset allocation ETFs will cost between 0.2 and 0.24 percent in MERS, while specialized ETFs will cost slightly more.
To compare, he entered some data into the GetSmarterAboutMoney calculator to determine the difference between investing $10,000 in an ETF with a 0.25 percent MER vs. a similar mutual fund with a 1.75 percent MER. He discovered that assuming 7% annual growth (before fees), the entire fund value after ten years would be $19,216.70 for the ETF and $16,680.96 for the mutual fund, a big difference.
Depending on your broker and the particular fund, you may also be charged a fee to buy or sell. If you plan on making frequent transactions, such as depositing money on a monthly or bimonthly basis, seek solutions with no transaction fees.
All investors must be fee-conscious – the less you pay, the more you keep from investment gains, Mr. Carrick adds. However, youthful investors, with their small account balances, have an additional incentive to be wary of costs. Paying $150 in commissions and fees on a $10,000 account reduces annual returns by 1.5 percent.
Where can I keep my ETFs?
ETFs are traded on the stock market and can thus be held in a brokerage account, Roth IRA, or a deferred tax account like an IRA, 401 (k), etc.
How can you get started investing in ETFs?
ETFs are popular among DIY investors due to their simplicity, and you can buy them on your own with an online brokerage account. The broker you select should provide instructions on how to buy and sell on their platform.
If you like to be less hands-on with your investing, you may want to consider using a Robo-adviser.