“Derek, my friend says he only invests in exchange-traded funds — can you explain what these are?”
The world’s first exchange-traded fund (ETF) was created in Canada in 1990, when the Toronto Stock Exchange (TSX) produced the Toronto Index Participation Fund.
Today, the TSX lists more than 250 ETFs, and they continue to gain in popularity among some investors.
At the end of 2012, the ETF industry in Canada included seven providers with nearly $60 billion under management.
One of the reasons for this significant increase in popularity is that they allow investors to diversify their investments into areas of the market to which they otherwise would have limited or no access to.
What are ETFs?
ETFs provide investors with participation in the returns of a commodity or an index of stocks. They are similar to mutual funds in that they hold a basket of investments.
However, unlike mutual funds, they trade on an exchange and do not rely on an individual manager to provide investment returns.
Instead, returns are correlated to the performance of the index or commodity. Investors can choose among ETFs that cover domestic and international equity markets, fixed-income indices, and indices offering exposure to specific sectors, as well as commodity ETFs, which invest in commodity futures markets. You can, for example, hold one ETF that tracks the S&P/TSX 60 index, one that tracks the price of silver, and another that enables you to invest in health care.
Are they cheaper than mutual funds?
Cost is often cited as a benefit of investing in ETFs; however, this is not always cut and dried.
Actively managed mutual funds have a portfolio manager that selects which securities to purchase and sell on an ongoing basis.
Traditional ETFs are passive investments — they track an index, commodity or other underlying securities without the need of an individual manager. These tend to have a lower operating cost which means that the management expense ratios (MERs) for ETFs are generally lower than those of mutual funds.
However, unlike mutual funds, ETFs have additional costs in terms of commissions and exchange fees. In addition, lack of liquidity for some ETFs may result in large bid/ask spreads.
Overall, which investment vehicle has lower costs? It depends on the actual investment and the way you invest. Some index mutual funds, for example, have lower MERs than actively managed ETFs. In some cases, the difference may be negligible or non-existent.
Increased portfolio diversification.
As previously mentioned, individuals can use ETFs to diversify their investments into areas of the market either very difficult or impossible to access, based on amount of investment or availability — for example, shares listed on the exchanges of emerging market economies such as India or China. They can also be useful for more proactive tactical investing, where investors may choose a specific sector or commodity — such as gold, oil or cotton — representing favourable value or growth potential.
Many investors who choose ETFs use them to complement mutual fund holdings as part of a diversified portfolio that may also include individual stocks and bonds.
Mutual funds and ETFs each have unique features and benefits. Mutual funds, for example, offer more choice in actively managed funds, and their lack of transaction costs when buying or selling can be attractive to investors making frequent contributions to retirement savings.
My final thoughts? While I believe that ETFs are valuable investment tools, you have to keep in mind that they are just that — one investment tool in a bench full of choices.
You wouldn’t use a chainsaw to fix a fridge, and you wouldn’t chop down a tree with a screwdriver. In short, make sure you pick the right tool for the job and make sure you stay disciplined with your investment choices.
Derek Fuchs is a wealth adviser with ScotiaMcLeod in Red Deer, and a certified financial planner, financial management adviser and a fellow of the Canadian Securities Institute. He can be contacted at email@example.com.