What is an ETF?
An exchange traded fund (ETF) is a type of security that trades on an exchange. Unlike stock in a publicly traded company or bonds, an ETF share gives buyers partial ownership of a pool of diversified securities linked to replicate the movement of an index. ETFs are often organized around a specific sector or geography.
How does an ETF work?
An ETF is a basket of securities which may consist of stocks, bonds, or other assets such as commodities. The asset mix of an ETF generally aims to track the performance of an index or asset class. ETFs offer the advantage of continuous trading throughout the day, similar to individual stocks, whereas mutual funds are restricted to buying and selling based on a net asset value (NAV) calculated after the trading day concludes. This key distinction allows ETFs to feature dynamic bid and ask prices.
While ETFs began as a passive investment strategy to generate returns
that replicated movements in market indexes like the S&P 500 or
the Nasdaq-100, much like indexed mutual funds, they are now a
convenient and affordable way to invest in the market with over 7100
ETFs trading as of 2021.
What are some types of ETFs?
Thousands of different kinds of ETFs are available on the market. These hold a wide range of diverse assets, track different benchmarks and indexes, and focus on holding certain types of securities, for example:
- Equity ETFs invest in a broad range of stocks, sometimes within a specific sector or based on a shared theme such as renewable energy or a geographic focus like Canadian-based publicly traded companies.
- Fixed-income ETFs invest in government or corporate bonds with a range of credit quality and short- and long-term limits. These ETFs provide investors with exposure to various fixed-income markets.
- Commodity ETFs invest in physical commodities such as gold, silver, or oil.
- High-Interest Savings Account (HISA) ETFs allow investors to manage their cash holdings using ETFs rather than another type of security.
- Currency ETFs are designed to track a single or a group of currencies against the value of the US Dollar.
- Specialty ETFs typically encompass leveraged ETFs, aiming to amplify returns on specific stocks or benchmarked indices. Inversely, inverse leveraged ETFs strive to capitalize on the declining performance of a benchmarked index or sector, generating potential profits in the process.
- Factor ETFs (sometimes called Smart Beta) can be considered as a crossover between Active management and Broad Beta indexing. Like the index, it is transparent and derives its consistency from a rules-based methodology. Factors identify characteristics which have been shown to drive long-term excess returns across all markets.
- Sustainable ETFs are built around alternative investments with an environmental, social, and governance (ESG) focus that are trying to impact the planet positively.
Passive vs. active ETFs
Passive ETFs typically benchmark and replicate the movement of an index like the TSX, the S&P 500, or fluctuations in a specific sector such as oil and gas or biotech. Originally most ETFs were passive and not actively managed – with the goal of recreating as faithfully as possible the underlying index at the lowest cost.
Semi-passive and active ETFs have gained popularity. Semi-passive ETFs are hybrid in nature. They usually follow basic models such as index ETFs, dividend ETFs or low volatility ETFs and act like a passive index ETF, albeit with annual, semi-annual, or quarterly rebalancing. They have lower MERs than an actively managed ETF but higher MERs than traditional ETFs.
Like other ETFs, active ETFs can be traded like stocks on an exchange. They are similar to mutual funds in that they are actively managed by fund managers seeking to outperform the market. Active ETFs have higher risks and buyers pay a higher management expense ratio (MER) than for passive or semi-passive ETFS. However, MERs for active ETFs are still lower than those for mutual funds.
ETF holdings can focus on specific sectors
Many ETFs are focused on a sector or industry. The portfolio is comprised of several stocks that are representative of a particular business area or service. For example, an ETF that tracks the technology sector may hold a diversified portfolio of technology-related stocks from various technology companies like Apple, Microsoft, and Google.
This strategy is based on the principle that by holding a diversified portfolio of stocks in a particular sector, the ETF can provide investors with targeted yet diversified exposure to that sector's performance and potential for growth. This serves as a useful way for investors to gain exposure to specific industries or sectors of the economy without having to research and then purchase individual stocks.
This is especially helpful to investors who are interested in a particular sector but who may not have the time or resources to evaluate individual companies within that sector. Additionally, sector ETFs can provide a level of diversification and risk management, as they typically hold a diversified portfolio of stocks within a specialized area of the economy.
It is important to remember that many different types of sector ETFs are available. These include ETFs that track broad sectors like raw materials or healthcare, as well as more specialized sectors like biotechnology or clean energy.
In Canada, financial services, energy, and raw materials constitute a large percentage of the sectoral ETF market, while other areas such as healthcare or technology are underrepresented. Adding sector ETFs, especially those that invest outside of Canada, can help with portfolio diversification. Sector ETFs are either weighted by a market capitalization or an equal weight approach.
ETFs can focus on specific geographic areas
Country-specific ETFs focus on a specific country or area like Canada or Europe. They might also include a range of industries within a country or group of countries such as emerging market economies, which might include Indonesia, Mexico and South Korea, or the BRICS nations – Brazil, Russia, India, China, and South Africa.
ETFs can invest in specific themes
Thematic ETFs are composed of a portfolio of stocks that represent a particular theme or trend. They are designed to track a specific investment theme, such as gender diversity or innovation or robotics and cybersecurity. For example, a thematic ETF focused on gender diversity might only invest in companies where at least 25% of board members are women.
Thematic ETFs can be a useful way for investors to gain exposure to a specific trend or theme that they believe offers long-term potential for growth. They can also provide a level of diversification and risk management, since they typically hold a variety of different stocks that represent those specific concerns.
How to choose an ETF?
Given the large number of ETFs currently available, deciding which ones to buy can be difficult. As a general rule, choosing ETFs based on your investment goals and timelines is a good place to start. Here are some factors and questions to consider when making your decision.
- Investment objectives: Is the ETF designed to generate riskier short-term gains or steady long-term growth?
- Expense ratio: How much of the ETF's value is directed to the costs of managing the fund?
- Performance: How has the ETF performed since inception?
- Liquidity: How easily can the ETF shares be bought and sold on the exchange?
- Methodology: What governs the stock asset allocation of the ETF? What criteria are fund managers using to select a stock? How are the different securities in the portfolio weighted? On what basis is a security removed from an ETF's portfolio of assets?
- Benchmark index: Two ETFs operating within the same sector may track distinct indexes, leading to variations in risk and returns. It’s important to note that some indexes include infrequently traded equities, making it more challenging to replicate their composition accurately.
- Diversity: The more an ETF is diversified, the better it reflects the performance of the intended stock category.
Find ETFs using the NBDB ETF Center
Watch this tutorial to learn how to compare ETFs with our ETF Center in the NBDB Platform.
Best practices when trading ETFs
Once you've decided on your ETFs, there are some simple strategies to keep in mind to ensure you execute the best possible trades. Here are some points to consider:
- Avoid making trades in the first 15 minutes and last 15 minutes of the trading day.
- Use limit orders to strike a balance between execution and price.
- Keep an eye out for market volatility.
- Focus on historical spreads and not only recent trading volumes.
- Look at bid/ask prices to assess the current market price.
- Keep in mind market time difference when trading international ETFs.
Advantages of ETFs
For independent investors, ETFs represent a versatile class of asset to include in a well-distributed and diversified investment portfolio. Here are some of the advantages to buying ETFs:
- 1. Diversifying your portfolio. ETFs are an excellent way to diversify your portfolio. Not only are they easy to buy, but their management fees are also typically lower than mutual funds or other types of available indexed funds.
- 2. Reducing volatility. Low volatility ETFs are designed to help reduce the risk associated with your portfolio without sacrificing returns by investing more heavily in “defensive” sectors such as consumer staples, utilities, and health care.
- 3. Liquidity. Most ETFs are highly liquid and can be traded throughout the day – a significant advantage that mutual funds or guaranteed investment certificates (GICs) simply cannot match. Even Bond ETFs allow clients to quickly sell their holdings without experiencing large fluctuations in their value, which is not the case with individual bond purchases.
- 4. Tax loss selling. Tax loss selling is a tax strategy that lets you apply the value of any ETF losses to offset the capital gains taxes that you might have to pay on any increase in the value of your other investments.
- 5. Fiscal efficiency. Exchange traded funds are typically more interesting from a tax point of view than mutual fund investments. But this doesn't mean you can avoid paying taxes on ETFs, especially when there’s a risk of paying double revenue on the dividends - a situation called phantom distributions – or when the ETFs include international securities.
- 6. Opportunity for alternative investing. Alternative investments can help you improve diversification, lower your portfolio’s volatility and smooth out its returns. Clients can now access to ETFs that invest in real estate, infrastructure, private equity, cryptocurrencies or even hedge funds.
- 7. Socially Responsible Investing (SRI). Ethical and responsible investing has become an important trend in recent years. Several issuers have launched ETFs that adhere to environmental, social and governance (ESG) investment principles. These investments are an excellent way for independent investors to participate in projects that benefit the planet.
Risks and disadvantages of ETFs
- 1. Market Risk. ETFs are subject to market fluctuations and volatility, which can result in losses.
- 2. Tracking Error. ETFs aim to replicate the performance of an underlying index, but there can be slight discrepancies that lead to tracking errors.
- 3. Liquidity Risk. Certain ETFs may have low trading volumes, resulting in wider bid-ask spreads and potential difficulty in buying or selling shares at desired prices.
- 4. Sector Risk. ETFs focused on specific sectors or industries may be more susceptible to risks associated with those sectors, such as regulatory changes or economic downturns.
- 5. Counterparty Risk. Some ETFs use derivatives or engage in securities lending, which introduces the risk of the counterparty defaulting on their obligations.
- 6. Currency Risk. ETFs that invest in foreign markets are exposed to currency fluctuations, which can impact the returns for investors.
- 7. Management Risk. The performance of an ETF is influenced by the decisions and expertise of its fund managers, so ineffective management can negatively affect returns.
- 8. Closure Risk. ETFs with low assets under management or limited investor interest may face the risk of closure, leading to potential liquidation of holdings.
- 9. Fiscal efficiency: Certainly, exchange traded funds are more interesting from a tax point of view than mutual investment funds. ETFs do not, however, avoid taxes, especially when they include international securities or when there’s a risk of paying double revenue on the dividends, called phantom distributions.
ETFs represent a dynamic and varied asset class for both new and seasoned investors. They demand less active management and provide greater distribution across a range of securities at a better cost. Not only is there an ETF to match the values, timeframe, and strategy of everyone interested in investing, but they also offer easy exposure to specific trends or themes that may offer growth potential.
Nevertheless, it is always important to remember that like all types of investing, there are risks – do your research, outline your goals, and invest thoughtfully.
Erin Allen has been a part of the BMO ETFs team driving growth since the beginning, joining BMO Global Asset Management in 2010 and working her way through a variety of roles gaining experience in both sales and product development. For the past 5+ years, Ms. Allen has been working closely with capital markets desks, index providers, and portfolio managers to bring new ETFs to market. More recently, she is committed to helping empower investors to feel confident in their investment choices through ETF education. Ms. Allen hosts the weekly ETF Market Insights broadcast, delivering ETF education to DIY investors in a clear and concise manner. She has an honors degree from Laurier University and a CIM designation.