What Is An ETF – The Nuts and Bolts
ETF’s are all the rage right now, and for good reason, they operate like a mutual fund in some ways. The best thing about them though is they trade like a stock. This allows you to easily diversify your holdings with an extremely low MER! We would call it the ‘democratization of the market’ in a way.
So what is an ETF exactly?
An ETF is a basket of stocks in basic terms. Imagine you wanted to buy every stock in the TSX and have exposure to the whole market. This is difficult from a monetary and logistic standpoint as you would have to rebalance it every day and account for all of the changes. You may also have to deal with all of the fluctuations, and we are talking about thousands of stocks. An ETF (e.g TSX Index ETF) solves this exact problem by creating a pool of all these stocks, rebalancing them. The best thing about it, is all you have to do is own a share of this, and guess what, this ETF trades like any other stock!
How does an ETF operate?
Any search you do for ETF’s will bring up this idea of a ‘creation and redemption mechanism’. This may sound somewhat complex at first, but really it relates back to the basket of stocks we mentioned. An ETF uses a dealer as its back office. It’s the dealer’s responsibility to have the shares available for the ETF’s use. In a typical day, stocks will move and fluctuate.What this essentially means is there will need to be some changes made to the product. At this point, the ETF will give some shares back to the dealer, or take some new shares. The dealer then will give back an equivalent amount of the ETF shares. All you need to remember is that it is a like for like switch, and the aim is to keep the ETF trading it’s net asset value, in line with all the underlying stocks it holds.
Benefits of ETF’s:
Total world dominance
ETF’s are a tool that allow you to own almost any industry or sector available. You can buy an ETF representing junior gold minors, the TSX index, Chinese small cap equities, and literally everything in between. You can even own the whole world with ETF’s like the MSCI World Index!
ETF’s are more tax efficient than mutual funds
The underlying reasons are basically that if a mutual fund had gains, they would pay these gains at the end of the year back to shareholders, creating a taxable event. In addition, if you sold your mutual fund units, the company would have to sell securities to make up for that. In the case of an ETF, there is less turnover, thereby keeping the securities in the ‘basket’. If you sell your ETF unit, you do it on the open market. All it does is just trades hands, which cannot be said for a mutual fund.
Funds that track an index, like ETFs and index mutual funds, generally offer lower expense ratios than conventional mutual funds.
I know what an ETF is … what now?
Once you have the basics down, it is worth looking at all the different variations available in Canada. One great site for this is the etf encyclopedia , which gives a simple list of all the ETF’s that trade in Canada. Now that we know what an ETF is, let’s look at some differences between them and a mutual fund.
ETF’s as a part of your Investment Portfolio (or your whole portfolio!)
You want to have a brokerage set up (Questrade offers zero commission on ETF transactions. Find out about Questrade here. If you’d like to explore other brokers, check this article out ). Once you have that done, it is time to start constructing an ETF portfolio. ETF’s can play a role in many different ways within your investment portfolio:
One of the beautiful parts of ETF’s is index investing, where you can create a portfolio of a few ETF’s that give you a diversified exposure to as many industries/countries as you see appropriate.
If you are happy with your equity portfolio, this can be supplemented with a currency hedged ETF to minimize your downside to currency fluctuations. These are quite common in the US and Canada, an example would be a US Health Care ETF Hedged to CAD, this would enable you to get exposure to the US healthcare industry while minimizing and apparent currency risk.
ETF’s can play a great role as an alternate category of your portfolio. They allow you to add the benefits of a specific sector or country/index as you see fit for your investment needs. For example, you may have a strong portfolio of Canadian financials and utilities, for their dividend yield, but lower risk exposure. You may want to supplement this with a higher risk emerging market or energy ETF to get some extra possibility of capital gains, or just plain diversification.