What are ETFs?

Exchange-traded funds, usually referred to as ETFs, are a class of securities that are bought and sold on global stock exchanges. An ETF is similar to a stock in the way it's traded and similar to a mutual fund in that it holds more than one security. ETFs are created by an ETF supplier (we like to call them “manufacturers”) who then make them available on the market. The manufacturer can actively or passively manage the securities held in the ETF. Actively managed funds attempt to outperform its chosen benchmark, which is usually an index. Passively managed funds simply work to replicate the benchmark's performance.

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Types of ETFs

ETFs began in the early 90s with a handful of offerings. Today, there are well over 5,000 ETFs available globally and more than 700 made in Canada. ETFs come in every shape and size. A market ETF tracks a particular index, including a foreign market like the Nikkei. You can invest in any type of bond with a bond ETF. You can get exposure to particular sectors, industries, commodities or investment styles with specific ETFs. 

How do ETFs work?

The simple answer is that ETFs are traded on a global stock exchange. But achieving the overall investment goal of the ETF requires a structure that ensures liquidity and price consistency. Without this in place, a large purchase or sale of ETF units could artificially increase or decrease the price of the ETF for a short time, resulting in negative consequences for investors.

In the ETF world, so-called “market makers”—usually bank-owned investment dealers or large institutional investors—play three important roles to maintain liquidity and price consistency.

First, they establish the upper and lower limits for bid and ask prices, which are based on the underlying securities held in the ETF plus a small profit. Second, they maintain a market where ETFs can constantly be traded. Third, they create new ETF units to satisfy investor demand.

While these are all behind-the-curtain aspects of ETFs, they're important to know in order to understand the complexity of these funds.

Advantages and disadvantages

PROS

  • no sales load, which means lower fees than mutual funds, unless you’re doing a lot of trading

  • access to almost any commodity, sector, market or country

  • new, innovative products are being introduced all the time

  • allows for quick entry and exit of markets to take advantage of short-term opportunities

  • can be bought and sold at any time on global stock exchanges

  • increased control over when capital gains are realized compared with mutual funds

  • ETFs allow you to hedge currency risk, if needed

CONS

  • frequent trades can become expensive, if not properly managed

  • it can be difficult for individuals and institutions to assess ETF characteristics on their own

  • second-guessing economic influences and short-term opportunities and risks requires information that can be hard to access and interpret without expertise

  • some ETFs are not liquid and a large purchase of shares will move the price noticeably

  • some ETFs may be difficult to sell down the road, if not widely held

  • there may be tracking errors, which result in performance discrepancies between an index and the ETF that’s supposed to replicate it

PERSONALIZED ASSESSMENT

  • How do ETFs fit into your investment strategy? Book a free portfolio review and we will make recommendations based on your unique investment goals.

Success is in the strategy

A successful ETF investment strategy incorporates global macro-level economic forecasting, quantitative risk ranking, disciplined portfolio construction and rigorous ETF evaluation criteria. In short, you need a repeatable methodology with a great track record, allowing an investor to take advantage of opportunities without undue risk.

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