The first Canadian ETF was created in 1989 and called the TIP-35, which tracked the TSE 35.  Since then, the ETF market has expanded considerably.  Currently, according to BlackRock, there are over 3,000 different ETFs available globally.

ETFs started out as a way for investors to tap into the returns of major stock markets using a nice, convenient package that traded like a stock – a miniature index.

With passive investment management, a computer could literally manage the portfolio because all it has to do is hold the same stocks that the market holds in the same proportion. In their purest form, ETFs provide low-cost diversification and efficient access for individual investors to various asset classes, industries and countries.

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Your returns equal whatever the index gains or loses minus a fee.  These fees look like a bargain compared to conventional mutual fund fees that can charge up to 2.5% or more.

A recent poll found that less than 20% of Canadians are familiar with ETFs, but once told about the benefits 74% said they would consider them.

34% don’t know how to get started or feel they lack the necessary knowledge.

65% would buy if they were as convenient to buy as mutual funds.

Which index?

An index is a group of stocks or bonds used to measure the performance of a particular market.  However, there are several different indexes and each performs differently.

Traditional stock indexes select the largest and most frequently traded companies and weigh them by their market capitalization (stock price times outstanding shares).  This is called a cap-weighted index and is the cheapest and most common.

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The go-to index for the broad Canadian market has been the S&P/TSX Composite, which includes about 250 stocks.

There is an increasing trend towards creating ETFs using more active strategies designed to beat the market.  Managers may deviate from the index and change asset allocations as they see fit.

  • Fundamental indexes are based on a company’s total sales, cash flow and dividends.
  • Equal-weighted indexes allocate each security to a fixed equal weight.
  • Leveraged ETFs use a range of strategies such as derivatives, futures contracts and options to amplify the moves of the underlying index. They attempt to achieve daily returns of 2 or 3 times the index.
  • Inverse ETFs are similar, but opposite, meaning they will gain double or triple the loss of a market.

Currency Hedging

When you invest in a fund that holds US or international stocks you must take currency conversion into account.  If our dollar rises against US$ or other foreign currency the value will fall.  Conversely, a falling loonie will boost Canadian returns.

Currency hedging is designed to smooth out the fluctuations in foreign exchange and deliver the full return of the underlying investments.  It will say “Hedged to CAD” in its name and probably cost a bit more.  You can also buy ETFs without hedging and this is recommended for long-term investors, as currency ups and downs will cancel each other out over time.

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Some International equity ETFs simply hold the US-listed ETF rather than buying the underlying stocks directly.

Advantages

ETFs are listed and tradable on stock exchanges and can be bought and sold any time throughout the trading day.  Holdings are posted online and updated on a daily basis.

They have improved the investment choices available to individual investors and are generally the lower-cost option versus a comparable mutual fund.

Risks

Look at the nature and purpose of the underlying index.  Is it well understood, or is it some obscure “proprietary” or narrowly defined approach that is hard to understand or verify?

Is the ETF leveraged in some way in order to enhance returns?  Leveraged and inverse ETFs are often marketed at Bear and Bull ETFs. They are definitely not for long term holders.

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Actively managed ETFs have the potential for higher taxable distributions.

Management fees

Keeping costs low is an essential part of index investing. There’s currently a price war going on and Canadian ETF management fees are now lower than ever.  A diversified portfolio can be held for as little as 0.12% in fees.

Too many investors just look at management fees and overlook their overall strategy and performance.  Cutting an extra .10% won’t make that much of a difference and switching can be expensive when your trading commissions wipe out any reduction.

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Don’t jump from one to another just because the fee is lower or holdings are larger.  Keep in mind transaction costs and possible capital gains.

The bottom line

The original purpose of ETFs was to passively track an index in a low cost, flexible, diverse and tax efficient manner.  Investors look for simplicity and transparency.  They know and understand what benchmark is being tracked.

The industry has very competent marketers, increasing the number and complexity of choices.

This may encourage investors to use them as part of an active trading strategy. Over-trading incurs unnecessary costs and reduces net returns.

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ETFs are not a cure-all.  They do bear risks, some of which may not be obvious or well understood.  Be sure to properly research any ETFs you are interested in and ensure it fits your purpose.

Carefully determine the appropriate risk level for your portfolio.  Make sure you have broad diversification.  Be disciplined and stick to your plan.

And, as always, be an informed investor.


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