As this investment product has now become an established solution for many investors, many people ask what is an ETF exactly? ETF stands for “Exchange-Traded Fund”. Not helping much right? This article will go in-depth to cover ETF investing strategy. In addition, a few myths regarding this popular marketable security will be debunked.
What is an ETF?
Instead of defining what an ETF is by textbook definition, let me give you this example:
After reviewing your portfolio and looking at the overall economic perspective, you determine you should increase your investment in the U.S. stock market. However, you don’t have a specific company in mind and you’d rather invest in a large number of holdings at the same time. This is how you can invest in an ETF. Your options would be SPDR S&P 500 ETF Trust (SPY) or iShares S&P 500 Index ETF (IVV). Those two ETFs will replicate the S&P 500 index return in your portfolio. In other words, instead of buying the 500 companies, included in the index, you can invest in an ETF and get the same result.
By purchasing an ETF, you indirectly hold shares of hundreds of companies thus fulfilling your investing strategy. You can achieve this as the ETF pools the investment of many investors together. Instead of buying 500 individual shares of each company included in the S&P 500, you buy a single symbol for a fraction of the price. By pooling other investors with your investment, the ETF is able to buy the 500 companies, or other derivative products, following the index. But wait, did I just define what a mutual fund is? The answer would be yes and no. If you have invested in a mutual fund before, you probably think that ETFs are a lot like them. In fact, ETFs are a lot more flexible than mutual funds for many reasons.
What is the difference between an ETF and a mutual fund?
There are many differences between EFTs and mutual funds. The biggest one is in regards to their structure. Remember ETF stands for “Exchange-Traded Fund”. The fact that they are “exchange-traded” means you can buy shares directly from any broker account. The transaction process works exactly like any other stock. In other words, it allows you to buy and sell ETF whenever you want throughout the day. As opposed to mutual funds where you can only complete your transaction at the end of the day, ETFs can be bought or sold intra-day. This enables you to have a world of trading opportunities. With this option you can then buy an ETF at 11am and sell it at 3pm during the same day. Another advantage is that you can also perform several strategies such as selling short, placing stop-loss or limiting orders. In addition to that, you can also buy ETFs on margins. Those strategies are not available when you invest in mutual funds.
Another greatly appreciated aspect of ETFs is the increased amount of disclosure and transparency that they provide. Most ETF’s do give out daily holdings on the issuer’s website along with information such as the fund’s NAV (net asset value). ETFs have one or multiple market makers in the market that compete to offer the best price to the end-investor which will often mean getting significant price improvements. For example, if you are buying single bonds you will be getting retail spreads which can typically mean being 1% away from actual value. It’s difficult to see the exact cost because on bonds there is no official “close”.
An ETF for any type of investment
Another advantage of an ETF is that you can easily find one that tracks exactly what you are looking for. The underlying strategies of various types of ETFs are limitless. Here are some of the pros of ETFs:
- You can track global markets as ETFs will replicate important indexes return such as the S&P 500 (SPDR), the Dow Jones (DIA), the MSCI world and even emerging markets.
- You can track all kind of investments as ETFs could easily follow commodity prices such as the crude oil (USO) or gold (GLD) along with treasury bonds or corporate bonds. Therefore, you are not limited to the world of equity. Your possibilities are infinite.
- You can invest in specific sectors. So, you believe the financial sector is poised for a strong return this year? Well, you can invest directly in this sector using XLF.
- You can double or triple your potential investment return with leveraged ETFs offering double or triple the underlying asset return. Can you imagine that? You can make 3 times the market… or lose 3 times more as well!
- You can even invest in the ETFs of ETFs. Now, why would you be content of building your own ETFs portfolio when you could opt to purchase single shares of an ETF thus regrouping many ETFs? It is a definite yes that investing in ETFs opens the door to a world of investing possibilities.
ETFs of ETFs
ETFs of ETFs could be the fiercest competitor to mutual funds. They have been built following the same needs using risk tolerance, time horizon and sector preferences metrics. So, you are looking for a balanced portfolio in order to generate sufficient dividends to pay off for your retirement in 20 years? Through a single trade, all your money could be invested in a diversified ETF, including several ETFs combined together, to meet your requirements. The biggest advantage of such strategy is to invest in a diversified portfolio at a very low fee.
Do ETFs perform better than mutual funds?
This is a complex question without a yes or no answer. There are thousands of mutual funds as well as thousands of ETFs. Therefore, even by spending numerous hours of research, we would not get a simple answer.
Nonetheless, we can establish a basis of comparison where mutual funds are actively managed and most ETFs are passively tracking an index (wide or narrow). Many financial researchers have proven that professional fund managers have difficulty beating their index over a long period. There are various factors that explain this theory.
The first of these factors is higher management fees (MERs). These are often charged by mutual funds and this reduces the fund manager’s ability to beat its index (with virtually close to 0% MERs). The second being the fact that the market is relatively efficient. This means that, often, there are small margins for a fund manager to find undervalued opportunities. Finally, the fact that some managers will chase performance may lead to underperformance following a bad trade.
For the little investor, ETFs tend to be a better choice due to their low fees, higher flexibility and their potential to follow the index return. This is opposed to the mutual fund’s inability to compete against major indexes.
Myth #1: ETFs are cheaper than mutual funds
There is a common belief where investors automatically think that ETFs are low cost investing products since mutual funds are among the most expensive. This perception comes from the fact that many ETFs are structures for a maximum of cost efficiency and they are a lot cheaper than mutual funds. If you compare an ETF following the S&P 500 index with an actively managed fund trying to beat this index you will notice that the ETF is probably 2% cheaper than the mutual fund.
However, with the rising of the ETF trend, several mutual fund manufacturers created their own version of index investment funds. Those funds have been built to compete against ETFs presumably lower fees.
In general, it is true that most ETFs tend to offer a lower cost structure than mutual funds. On the other hand, make sure to verify management fees for both type of products before making a final decision. To give you a few facts, the average mutual fund in Canada charges 2.35% while that average in the US is 1.31%. In both cases these percentages are multiples of what the average ETF charges.
Myth #2: ETFs are complex investments
By reading this far on this topic you’ve probably noticed that ETFs are not more complex than most investing products. In fact, it is quite the opposite. When you conduct research to buy an ETF, you first select what you want to track. As there is an ETF tracking any kind of investment or strategies, you can easily build your portfolio according to your needs.
If you make the decision of avoiding complicated strategies or investing in ETFs using derivatives, such as the one doubling or tripling an index return, ETF investing is quite easy.
The couch potato ETF approach is an accurate reflections of how ETF investing can be very simple. By selecting a few of ETF’s major tracking indexes such as the S&P 500, the MSCI world and the bond market, you can rebalance your portfolio every 6 months thus helping your portfolio to grow. This kind of strategy is applied for investors who lack time to actively manage their portfolio and are concerned about paying high management fees.
In general it is our belief that investors should stick to simple ETFs, unless they have a specific view, when investing for a long-term retirement portfolio. Sure, you can use an ETF that gives you exposure to Small Cap Stocks in China, but if you stick to 5-6 ETFs for your “core” portfolio (domestic stocks, 2-3 intl ones, domestic and intl bonds), you’ll be well off. Those are also generally the cheapest. Why? Because in financial markets, the more “complex” the product, the more difficult it is to compare fees between products. This creates higher margin products for financial institutions. In general, using 5-6 ETFs for an ETF core and having a few others to execute specific views seems like the best approach.
Myth #3: An ETF is an ETF
This is not true. All ETFs are not equal. In fact, while many ETFs from different companies may track the same index, there are differences among each of them. The way they are structured, the methodology used to track a specific market segment and how the money is managed can influence both their investment return and their fees.
Therefore, you are not losing your time if you compare different ETFs tracking the same index. ETFs also serve many different purposes and some products, such as leveraged ETFs or volatility ETFs, should be used as trading/short term holding ETFs.
Myth #4: ETFs are for Market Timers and Day Traders
The fact that ETFs can be traded several times throughout a single day often lead people think this product has been designed for traders or market timers. In fact, nothing could be further from the truth. While you can use ETFs to make intra-day trades or enter in the market at a specific timing, you can also very well hold your positions for several years.
A diversified portfolio of ETFs could be built with a long-term horizon like a balanced mutual fund. You can hold those ETFs for several years and simply rebalance your portfolio every six months without changing your strategy. Since ETFs offer low management fees, it is in the investor’s advantage to hold them for a long time and then proceed to spread the commission trading cost over several years.
Myth #5: Using An ETF’s Volume Is A Good Way To Judge Its Liquidity
This is a widely held belief that investors should only buy ETFs that trade crazy volume and in some cases that is true as it’s certainly one factor that should be considered. However, even if you compare SPY (SPDR S&P500) and IVV (iShares S&P500) ETFs, you might determine that SPY is a lot more liquid because it trades several times more per day. In reality, both ETFs are quite liquid. An ETFs liquidity is determined by the liquidity of the underlying holdings. Many market makers are competing to trade against buyers and sellers to ensure the ETF will not move away from its actual value.
Final thoughts on ETFs
ETFs are one of the most effective, flexible and cheap types of investments on the stock market. With very limited resources and time, you can build a rock-solid portfolio that will cost a lot less than most mutual funds. On the other side, as it is the case with any other type of investment, the investor methodology used to build one’s portfolio will generate most of its returns. Poor choices of ETFs will also result in a poor return portfolio.