What's an ETF?

Want to start investing but feeling a bit overwhelmed by your options? We understand.

From mutual funds and bonds to stocks and REITs, figuring out precisely what to invest your hard-earned money in isn’t always easy.

To get you started, we’ve put together this guide to one of the most popular investment options on the market today: the ETF.

In this article, we’ll discuss what an ETF is and how it works. We’ll also give you some insight into the advantages and disadvantages of investing in ETFs so you can decide if they’re the right option for your needs.

What is an ETF?

An ETF, or exchange-traded fund, is a type of investment vehicle that bundles multiple assets together so they can be traded as a single product on a financial market.

This definition might sound like a bunch of technical jargon, so we’ll break it down into its various components.

First and foremost, an investment vehicle is anything that you might choose to invest in, be that bonds, stocks, or even fine art. An ETF is just another type.

What makes ETFs special, however, is that they are a collection of different assets that are traded together as one unit. Furthermore, shares of ETFs can be bought and sold by investors on a financial market, like the Toronto Stock Exchange (TSX), throughout the trading day.

How do ETFs work?

Now that you have a big picture overview of what an ETF is, let’s do a deep dive into how it actually works.

As we’ve mentioned, ETFs are bundles of different assets. Depending on the type of ETF you invest in (more on that later), those assets could include shares of stocks, bonds, commodities, or even other ETFs.

To establish an ETF, the fund’s provider (normally a financial institution like Vanguard) purchases all of the assets that they want to include in the fund. Depending on the goals of the fund, these assets could include anything from Canadian-listed stocks to foreign bonds.

Regardless of what’s in the ETF, however, the fund’s provider will then bundle these assets together, get a ticker symbol for the fund, and then list it on an exchange, like the TSX.

At this point, individual investors, such as yourself, can buy and sell shares of the fund during the trading day, just like you would with a stock. As with stocks, when an ETF’s trading price goes up, so does the value of your investment. If the ETF’s price goes down, well, your investment’s value does, too.

Oh, and we should note that ETFs aren’t free. In order to pay for the management of the fund, the majority of ETFs charge what’s known as an expense ratio.

This ratio is expressed as a percentage and it tells you how much you’ll pay in fees per year. For example, an expense ratio of 0.08% will cost you $0.80 in fees per $1,000 invested in a fund.

The good news is that ETF fees tend to be relatively low (at least when compared to mutual funds). They’re also automatically deducted from your earnings, so you won’t have to pay for them out of pocket.

What are the different types of ETFs?

At this point, you understand what ETFs are and how they work. Now, it’s time to talk more about the different types of ETFs that are on the market.

Just like with stocks, there are thousands of different ETFs out there for you to invest in. However, not all ETFs are created equal as they all have different goals they’re striving to meet in order to make money for their investors.

As there are many types of ETFs in the world, we couldn’t possibly list them all there. But, we can categorize ETFs either by the fund’s management strategy, asset class, geographic focus, and theme.

ETF Management strategies

When it comes to fund management strategies, there are two main types of ETFs. These include:

• Actively managed – As their name suggests, actively managed ETFs are actively managed by their fund managers. This means that there’s a human fund manager that makes game-time decisions about what stocks, bonds, and other securities to buy or sell in the fund’s portfolio based on current market trends.

• Passively managed – Also known as “index funds,” passively managed ETFs are set up to track a specific type of stock index or market benchmark, such as the Canada S&P/TSX. These funds try to match the index or benchmark by buying up shares of stocks and securities listed in those indexes.

ETF Asset classes

In addition to the fund’s management strategy, we can further categorize ETFs based on the types of assets that they invest in. The most popular asset classes that you’ll find in ETFs include:

• Stocks – Arguably the most popular type of ETF, stock ETFs invest in various foreign or domestic stocks based on the fund’s goals.

• Bonds/Fixed Income – Unlike stock ETFs that invest in equities, bond and fixed income ETFs invest in government, corporate, international, and municipal bonds, based on the fund’s priorities.

• Commodities – Commodities ETFs set out to buy up large sums of various commodities, such as precious metals. You may also find funds that invest in agricultural goods like livestock or natural resources like oil.

• Real Estate Investment Trust (REIT) – REIT ETFs (yes, that’s a lot of acronyms) invest in companies that own income-producing real estate. These are often companies that own apartment buildings or corporate offices, which they rent out for a profit.

"An ETF, or exchange-traded fund, is a type of investment vehicle that bundles multiple assets together so they can be traded as a single product on a financial market."

ETF Geographic focus

All ETFs invest in securities, like bonds and stocks that come from a particular geographic region of the world. Depending on the fund’s goals, a given ETF might invest in the following types of geographic regions:

• Domestic – A domestic ETF is one that invests in securities from your home country. So, a Canadian-focused ETF would have Canadian stocks, bonds, and other securities in its portfolio.

• Foreign – Also called international ETFs, foreign ETFs exclusively invest in non-domestic securities. For example, you can find ETFs that only invest in US-based stocks.

• Global – Global ETFs offer exposure to securities from all over the world, including in both domestic and foreign markets.

• Region-specific – Some ETFs limit their focus to a specific region, like East Asia or the Americas.

ETF Themes

While some ETFs seek to track a market index, some funds are designed with specific themes in mind. These themes can vary widely from fund to fund, and they’re a great way to expose your portfolio to a specific industry. Some potential ETF themes you might encounter include:

• Sector – Sector-based ETFs are some of the most common thematic-based funds. These funds invest in a specific industry, like healthcare, information technology, or aeronautics.

• ESG investing – ESG (environmental, social, and governance) investing is all about investing in companies and industries that promote ethical business practices. Investing in an ESG-focused ETF can be a fantastic way to build a sustainability-focused portfolio.

• Specialty – Similar to sector-based ETFs, specialty funds focus on assets that are within a specific industry. However, these funds tend to be much more nuanced, focusing on niche industries like green technology, cryptocurrency, robotics, or marijuana.

Types of ETFs: The bottom line

As you can see, there are many different types of ETFs on the market from which you can choose. Understanding the types of ETFs can make it easier for you to find a handful of funds to invest in, especially when you’re faced with thousands of choices.

Do keep in mind, though, that there’s no such thing as the “perfect” ETF. Each type of ETF is designed for a specific type of investor, so the key is finding the various fund types that are right for you.

Like any investment product, ETFs come with their own advantages and disadvantages. Understanding the pros and cons of a potential investment is essential if you want to build a solid portfolio. To get you started, here are some of the key benefits and drawbacks of in ETFs.

Advantages of ETFs

When compared to other similar investment products, like stocks and mutual funds, ETFs offer a number of key advantages. Some of the primary benefits of ETFs include:

• Lower expense ratios than mutual funds

• Highly liquidity

• Thousands of options to choose from

• Can offer built-in diversification

• Easy to buy and sell throughout market open hours

• Purchase price starts at the cost of a single share

Disadvantages of ETFs

Although ETFs have been a popular investment vehicle since their inception in the 1990s, no investment is without its flaws.

When compared to investing directly in stocks, bonds, and common, the primary disadvantage of investing in ETFs is that you don’t get to make any day-to-day decisions about what the fund invests in. Although relatively uncommon, this means that a fund manager could completely misread the market at any given moment.

For many investors, this lack of autonomy is actually an advantage because it frees you from having to do in-depth market analysis. But for active investors who would rather hand-pick their stocks, bonds, and other securities, ETFs aren’t always the best choice.

How do I invest in ETFs?

Investing in ETFs is a multi-step process, but the good news is that it’s fairly straightforward. Here’s how it works:

1. Open a brokerage account. The vast majority of people who invest in ETFs do so with an online brokerage. There are dozens of different online brokerages in Canada alone, so there’s likely a great option out there for you. Many also offer $0 trades on ETFs, so you can save money as you invest.

2. Research your future ETFs. A quality investment strategy starts with knowing what you’re investing in. You’ve already made a good first step in the research process by learning about ETFs in this article.

3. Place a buy order. Once you find the ETFs you want to invest in, you’ll place a trade to buy shares of that ETF through your online brokerage.

4. Monitor your profile. After you buy your ETFs, it’s time to start monitoring your profile. However, unless you’re an experienced investor, it’s usually not a great idea to start buying and selling ETFs with every slight change in the market as this can lead to serious losses. Most folks plan to hold their ETF investments for at least a few years before selling in the hopes of turning a profit.

Are ETFs a good investment?

ETFs are a popular investment product, so you’ll see them in the vast majority of investors’ portfolios. They offer a number of great benefits when compared to mutual funds and stocks, which makes them a nice choice for both active and passive investors.

However, the key to investing is to find various investment vehicles that meet your unique financial goals. If you’re the type of person that wants a relatively simple, highly liquid, and fairly low-cost investment tool, ETFs might be a good choice.