Investing in exchange – traded funds (ETFs)
Investing in ETFs, depending on an investor’s unique situation and long-term goals, may be a suitable approach to building a well diversified portfolio.
Two of the most suitable ETFs are broad market stock ETFs and broad mark bond ETFs. Broad stock market ETFs are designed to match the performance of indexes such as the S&P 500. However, you must be careful because some ETFs that are referred to as “broad market” may not be that well diversified. Some indexes, such as the S&P TSX Composite, are heavily weighted in only two or three sectors. This means that an investor must understand how an ETF is constructed and weighted before investing.
While broad market ETFs can be suitable for an investor, there has recently been a wave of sector specific, niche and leveraged ETFs released. These funds are unnecessary, riskier and investors may be tempted to trade these specialty ETFs more frequently.
What is an exchange-traded fund (ETF)?
An ETF is a basket of securities that trades throughout the day on an exchange. In general, ETFs are passively managed portfolios that are designed to track the return of a particular index. Since ETFs trade on an exchange in the same way as a stock, they are priced continuously and the price fluctuates throughout the day. ETFs may pay a dividend if the dividends of the stocks in the portfolio exceed the ETFs expense ratio (which is the amount shareholders pay annually in expenses and fees).
Five characteristics of an ETF
1. Passive management | The goal of most ETFs is to mirror the return of their benchmark indexes. This is one way in which ETFs differ from actively managed mutual funds – mutual funds try to beat the return of their benchmark indexes.
2. Tax efficiency | ETF investors can incur passive capital gains while holding shares if gains are produced by the trading that is conducted within the portfolio. This can cause tax consequences for investors who own the shares. Since ETFs hold the same securities as their indexes, stocks are usually only added to or removed from the portfolio when there is a change in their underlying index, which happens less frequently for broad stock market indexes. This limited turnover reduces the potential for capital gains to be generated and passed on to ETF shareholders.
3. Relatively low expenses | ETFs have an annual expenses ratio for management and other expenses of the fund. However, since most ETFs are not actively managed, these expenses are typically below that of the average actively managed mutual fund.
4. Trading flexibility | Since ETF shares trade like stocks, they are subject to many of the same trading rules. ETF shares can be purchased and sold using market, stop or limit orders. Also, they can be traded throughout the day and are priced continuously.
5. Transparency | The securities held in an ETF are always known. Since share trade throughout the day, the fund’s holdings must be disclosed in order for the shares to be correctly priced. In contract, mutual funds do not disclose their holdings with the same frequency.
Five things to consider when investing in ETFs:
1. Passive management | The securities included in the underlying index determine what is held in an ETF. ETF managers, in general, do not consider the company’s fundamentals, included its growth prospects, financial health or valuation when decided if it should be part of the ETF. This means that ETFs are only designed to match a benchmarks return, but there are some actively managed mutual funds that have been able to consistently beat the benchmarks return.
2. Return may differ from the index | ETFs may not return exactly the return of the index they are supposed to mirror because of the funds expenses and it may be cost prohibitive to own every security contained in a certain index.
3. Market trading impact | The price of an ETF is determined by its net asset value (NAV); however, since ETF shares are traded on an exchanged there is a supply and demand factor for ETF shares that must also be factored into value considerations. This trading impact is felt most when there is a marked imbalance between the supply of and demand for ETF shares.
4. Short track record of performance | The majority of Canadian ETFs have less than three years of performance data. Without a longer period of performance data available, it is hard to gauge how an ETF will perform in different market cycles and conditions.
5. Overlap individual holdings | As mentioned earlier, some “broad market” ETFs are highly concentrated in certain sectors and even certain companies. These companies are often held in mutual funds and even strong enough to warrant owning individual shares. When investing in an ETF, you need to know how it’s constructed, what its major holdings are and make sure you other investments don’t create overlap and over-concentration.
There is a lot of debate amongst financial bloggers and those in the financial sector about the merits of ETFs. What I hope this article demonstrated was that ETFs are neither inherently good nor bad for your portfolio. Their use is not for everybody. Whether you use ETFs depends on your goals, the amount you have to invest, your exposure to certain sectors and even your belief in someone’s ability to beat the market.
ETFs can make up a part of a well-diversified portfolio, but as with all investments you must be safe and make sure you are properly diversified. Even though diversification cannot eliminate risk, proper diversification will help your reduce your risk. If ETFs help you diversify, they may work for you.