Need-to-know facts for low-cost diversification

by Bryan Borzykowski

For decades, mutual funds were the go-to investment for Canadians. While they still hold most of the country’s investment dollars, exchange-traded funds have gained ground and continue to grow strong. There are many reasons why investors are turning to ETFs – they’re cheaper, for one – but there are still a lot of people who aren’t familiar with how this security works. This Q&A looks at some of the basics you need to know about ETFs.

How are ETFs different than mutual funds?
Mutual funds are baskets of stocks or bonds chosen by fund managers, while most ETFs are a collection of equities or fixed income securities that look exactly like a specific benchmark. A standard Canadian equity ETF, for example, will usually hold all of the S&P/TSX Composite Index. A Canadian equity mutual fund, on the other hand, will hold whatever stocks the portfolio manager thinks will offer the most upside.

The other primary difference is the way they’re bought and sold. Mutual funds are sold by registered representatives, who place your order with the mutual fund company. ETFs are traded on exchanges, just like stocks. Investors can easily buy and sell ETFs at any time during trading hours, while mutual fund holders have to wait until the end of the day before their order is executed.

Why would someone want to own an ETF?
There are many reasons, but the two main ones are cost and diversification. Expense ratios – the percentage of your investment you pay each year to own the fund – are much cheaper for ETFs than they are for mutual funds. The average management expense ratio (MER) on a domestic mutual fund is about two per cent. Investors can purchase ETFs with fees that start at 0.05 per cent. And while two per cent doesn’t sound like much, the difference can make up to 40 per cent of your total returns disappear over a lifetime of investment.

To the second point, buying an ETF gives an investor instant diversification at a very low cost.

How can someone build a portfolio with ETFs?
Since each individual ETF is already so well diversified, it’s possible to create a solid portfolio by owning a handful of these funds. For an investor who doesn’t want to regularly tend to their investments, some experts recommend holding just four ETFs – three equity funds that follow Canada, the U.S., Europe and emerging markets, respectively, and a Canadian bond fund.

What if I want a little more variety?
One of the pros – and some say cons – of ETFs is the sheer number of them. Globally, there are about 4,000 funds, with the majority of them originating in the U.S.

Canadian investors can own nearly any ETF on the market, whether it’s created by a domestic company or not. This gives people a lot of choice. If someone’s a fan of dividend stocks, they can own dividend-producing ETFs. If they think Japan is going to do well, they can own an ETF that tracks the Nikkei. If someone wants to get adventurous, they can buy an ETF that follows social media stocks, robotics companies and even companies based in Nashville.

But I thought they track indexes? There’s a social media index?
ETFs were originally created to track the main indexes. As their popularity has grown, a number of companies have developed their own indexes with the sole purpose of getting an ETF to track it.

As with any investment, it’s important for investors to understand what they’re getting themselves into before they buy. They should look at the fund company’s website, fund fact sheet, the ETF’s returns and its inception date, as many of these funds are brand new and don’t have much of a history. Compare its fees and anything else that will help you determine whether the reward is worth the risk. Unless you’re a seasoned DIY investor, talk to a financial advisor.
How are indexes created?
An index is essen-tially a fictional portfolio of stocks that represents a particular part of the market. The S&P 500, for instance, was created by Standard and Poor’s to track the perform-ance of America’s 500 largest companies. The main indexes are meant to give investors some insight into how a market is performing.

There are several companies, such as Standard and Poor’s, that are in the business of creating indexes. Essentially, they come up with rules and calculations to determine which stocks should be part of an index. But they can create indexes that, ultimately, track anything. That social media ETF? It was created by Solactive, which came up with a way to track the price movements of social media, file sharing and other web-based businesses.  

As a mutual fund grows or contracts due to investor purchases and redemptions, the fund has to buy or sell some of the underlying portfolio. That can trigger tax consequences, such as a capital gain.
— Pauline Shum is a professor of finance at the Schulich School of Business, York University

Are ETFs more tax efficient than mutual funds?
They are. I’ve asked Pauline Shum, a professor of finance at the Schulich School of Business, York University, to explain how it works.

“As a mutual fund grows or contracts due to investor purchases and redemptions, the fund has to buy or sell some of the underlying portfolio,” she says. “That can trigger tax consequences, such as a capital gain. Changes in ETFs can be done with in-kind exchanges between ETF units and the investments that make up the fund, so capital gains aren’t triggered.”

That means that more of your money stays invested to compound over time, until you sell your ETF units.

Do ETFs offer any other advantages over other investments?
Because ETFs trade like stocks, they’re a lot more liquid than mutual funds, which trade once a day.

The larger ETFs generally also have favourable volumes (the number of units traded each day) and bid-ask spreads (the gap between what the buyer wants to pay and the seller is willing to accept), two key measures of liquidity.

That’s ideal for everyone, but especially institutional investors who may want to buy and sell large quantities of ETFs at one time, says Shum.

“These funds, especially the bigger ones, have small bid-ask spreads,” she says. “It’s often better than the bid-ask spread of the ETF’s underlying assets, which means investors can get a better price.”

Bryan Borzykowski’s work appears in The New York Times, CNBC, CNNMoney, The Globe and Mail, Canadian Business, Maclean’s and other publications.

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