ETFs 101: What are exchange-traded funds?

If you’ve read anything about investing, you’ve heard of ETFs. Short for exchange-traded funds, they’ve become a popular option for investors looking for easy diversification without a lot of fees attached. But what are they exactly, and how do they work? This guide explains.

What is an ETF?

An ETF is essentially a basket of investments such as stocks or bonds. In this sense they’re similar to mutual funds, but unlike mutual funds, shares of ETFs can be traded throughout the day on an exchange, much like an individual stock.

The first ETFs were created in the 1990s to offer individual investors a simple, liquid way to invest in entire market indexes, such as the S&P 500. They’ve become hugely popular: In Canada, there were a record 201 ETF launches in 2021, and there are more than 1,200 ETF options overall.

An individual ETF is a specific grouping of investments. There are niche ETFs that hold various investments that fit a particular profile – clean energy, for instance – while asset allocation ETFs can be thought of as “an instant portfolio of Canadian, U.S. and international stocks, plus bonds designed for a particular investing need.”

What are the benefits of ETFs?

There are three key benefits to ETFs: Diversification, lower fees and the convenience they offer.

1. Diversification

One thing many investors like about ETFs is their simplicity: They provide diversification at a low cost. This is especially true for DIY investors who don’t want to devote all their time to managing a complex portfolio. “The idea is not to beat the market, but rather to be the market,” writes Globe and Mail contributor Joel Schlesinger. History shows that for the most part, after fees, actively managed portfolios – those in which professionals are choosing what to invest in – don’t perform any better than markets overall, he adds.

2. Low fees

That leads to the second advantage of ETFs over other investment tools: They tend to have low fees. Globe columnist Rob Carrick likes asset allocation ETFs in particular, which offer a fully diversified portfolio in a single package. “The cost of owning asset allocation ETFs is extremely low, and the cost of buying them ranges from zero to just under $10 per purchase,” he writes.

3. Convenience

Portfolio manager Dan Bortolotti is also a fan of asset allocation ETFs, because of their simplicity. You just buy one thing and keep buying it while it rebalances itself automatically. “When you add new money to your portfolio,” Mr. Bortolotti says, “you don’t have to decide where to allocate it. You just buy more shares of the only ETF you own. That way every contribution doesn’t turn into a market-timing decision.”

What kinds of ETFs can I buy?

Since ETFs were introduced three decades ago, the bulk of capital invested has been in low-cost index funds that cover wide swaths of the market. Still, despite the general tendency to get fees as low as possible, ETF providers are also launching more niche active management and sophisticated strategies that come with higher costs.

Many experts recommend that investors pick the low-cost ETFs with broad diversification as a simple, cheap and effective strategy. “Your biggest determinant of success, if you are an index investor, is to reduce the cost because every basis point that you pay to get exposure to that index is going to work against you,” says Mark Noble, executive vice-president of ETF strategy with Horizons ETFs Management (Canada) Inc. (A basis point is one-hundredth of a percentage point, or 0.01 per cent.)

That said, there are also a wide range of niche ETFs covering just about everything under the sun.

• Crypto ETFs hold shares in specific cryptocurrencies such as bitcoin or ether.
• Real estate investment trust ETFs contain shares in REITs covering various sectors such as housing and retail.
• Sustainability-focused ETFs offer investors the chance to align their holdings with their values by choosing funds that either use environmental, social and governance factors in their buying process, seek to make an impact around ESG-related issues or invest in a specific environmental sector such as water.
• And for those who need a convenient place to park some cash, high-interest savings ETFs invest mainly in high-interest savings accounts and deposits from big banks.

How do ETF fees work?

When you own ETFs you pay a percentage of your holdings in fees. This is largely expressed in one number, the management expense ratio. The MER is the main cost of owning an ETF on a continuing basis and will vary depending on the product. For asset allocation ETFs, says Mr. Carrick, you can expect to pay about 0.2 to 0.24 per cent, while MERS for niche ETFs tend to be a bit higher.

For comparison, he plugged some numbers into the Ontario Securities Commission’s GetSmarterAboutMoney calculator to see the difference in investing $10,000 in an ETF with an MER of 0.25 per cent versus a similar mutual fund with an MER of 1.75 per cent. He found that the total fund value after 10 years, assuming 7 per cent annual growth (before fees), would be $19,216.70 for the ETF and $16,680.96 for the mutual fund – a significant difference.

You may also need to pay a fee to buy or sell. Whether this is the case depends on your broker and the specific fund. If you want to make frequent transactions, such as putting money in on a monthly or biweekly basis, it’s worth looking for options with zero transaction fees.

“All investors need to be fee-conscious – the less you pay, the more you keep from the returns generated by your investments,” Mr. Carrick writes. “But young investors, with their small account balances, have added reason to mind their fees. Paying $150 in commissions and fees per year on a $10,000 account drags down returns by 1.5 per cent a year.”

Where can I hold ETFs?

ETFs are bought and sold on the stock market, and as such, you can hold them in an RRSP or TFSA as well as in a nonregistered account.

Mr. Carrick also recommends ETFs to those putting money into RESPs to save for children’s education. “Consider setting up an RESP account at an online broker and using it to invest regularly in an asset allocation exchange-traded fund, also known as a balanced ETF,” he writes.

He suggests that a more aggressive portfolio is a good choice when kids are young, and money can be shifted into more conservative options as they grow up. “My own RESP strategy was to dial back the aggressiveness somewhat when our boys began high school and then take the risk out completely in the Grade 12 year by moving into guaranteed investment certificates,” he writes. “At that point as a parent, your job is to preserve what you’ve built through years of RESP contributions.”

How to get started with investing in ETFs?

Because of their simplicity, ETFs are popular with DIY investors, and they’re easy for you to buy on your own with an online brokerage account. The broker you choose should offer an explanation of how to buy and sell on their platform.

Rob Carrick’s ETF Buyer’s Guide 2022: The complete series

If you’d rather be less hands-on, you might want to choose a robo-adviser to manage your investments. They’ll pick a selection of ETFs matched to your personal investment profile and balance your portfolio automatically.