—  WHAT IS AN ETF?  —

An Exchange Traded Fund, or ETF for short, is simply an singular investment product which holds a basket of underlying securities (such as stocks and bonds) and trades on an exchange. Usually, an ETF tracks or selects stocks from an Index according to some preset rules. For example, the U.S. S&P 500 is a market-capitalization weighted Index which is comprised of 500 of some of the largest U.S. companies by market capitalization. An ETF tracking this index, such as Vanguard’s S&P 500 ETF (Ticker: VOO) exists to provide investors with a quick and easy method of investing in 500 stocks at once.

— WHAT ARE THE BENEFITS OF USING ETFS? —

ETFs have many advantages: they are usually low cost, are very easy to access and trade, allow investors to target certain market segments, and are tax efficient. Let’s now go over some of these advantages in more detail.

A major selling point for investors is that ETFs are usually low cost investment products. It’s safe to say that it would cost an individual far more in trading fees to purchase 500 individual S&P 500 stocks than the annual management fees an ETF provider will charge. Minimizing fees is one of the most important things an investor should strive for when selecting an ETF. In this way, they are vastly superior to most mutual funds.

Another key advantage ETFs hold over mutual funds is that they are fully transparent. Whereas a mutual fund manager may make many trades throughout a period and only report a snapshot of the fund’s holdings every month or quarter, there is no guesswork about what an ETF is holding at any particular time. Since they often track an Index, you can just look at the Index constituents whenever you’d like. iShares by BlackRock, which is the largest ETF provider in the world, publishes and makes available for download the daily holdings for some of its more popular ETFs. Even some of the lesser known ETFs are available for download on a weekly basis. This sort of transparency is so important for the investment industry and is what we, as investors, should demand with any investment product we purchase.

ETFs can also provide automatic diversification in just a single trade. Broad-based Index ETFs such as those tracking the S&P 500 give you access to a huge basket of stocks spanning all 11 sectors and over a hundred different industries. Investors can also select specific sector ETFs for targeted exposure. For example, if you are looking to invest specifically in a basket of U.S. technology and telecom stocks, State Street Global Advisors has you covered.

Finally, ETFs are tax efficient in two ways. First, there is very little turnover of stocks, because turnover only happens when there are additions or deletions from the underlying Index and these happen to be few and far between. Since the ETF Manager does not have to perform as many trades, it has fewer realized capital gains and thus, lower taxes on those gains. Second, since ETFs are traded just like individual stocks, there are no tax consequences if you don’t sell your units. With mutual funds, however, a manager’s trading activity may result in capital gains for the Fund even if you do not sell your units. In such a situation, you will still have to pay taxes on those distributions.

—  WHAT ABOUT THE DISADVANTAGES? —

ETFs aren’t perfect, of course, and although they do provide a certain level of diversification, this may also cause investors to believe they are properly diversified if they just own an ETF. Unfortunately this is not true, as many broad-based Index ETFs are heavily weighted in just a few sectors. In Canada, for example, the S&P/TSX Composite Index is dominated by financial and resource stocks. There is very little exposure to Consumer Staples, Utilities, and Health Care - something an investor should keep an eye on when selecting an ETF or ETFs.

Remember that in order for a fund to operate, they have expenses - legal fees, accounting fees, trading fees, the fees paid to the managers, etc. This is all bundled up into a single figure known as the Management Expense Ratio, or MER and is expressed as a percentage fee the ETF Provider automatically takes annually. Now you can imagine that as more people invest in the ETF, the more fees the Provider receives. It eventually gets to a point where the fund’s total revenue from the MER exceeds what is necessary to operate the fund, so they are then in a position to reduce fees. This is great news and sends a strong signal to investors - the more you invest with us, the cheaper it will be.

With less popular ETFs, however, the MERs are usually much higher because they just don’t have the asset base to get their fees down. This is unfortunate, as there are many great ETFs out there which could help investors out a lot but they are deterred because of the higher fees. The differences can be drastic as well. Take the S&P/TSX Capped Composite Index ETF by iShares which has an MER of just 0.06%. If you wanted to supplement this ETF with targeted exposure to the Utilities sector, you would then have to pay an MER of 0.62% for its Capped Utilities Index ETF. If an additional 0.56% seems reasonable to you, keep in mind that this is an expense charged every year. According to Larry Bates’ Fee Calculator, you’ll get to keep 98% of annual 8% gains over 25 years with an MER of 0.06%; with an MER of 0.62%, just 84%. The lesson here is simple: fees compound as well, so aim to keep them as low as possible! For many people, this may mean just buying a few individual stocks which of course have no recurring fees.

One other disadvantage some ETFs have is a high tracking error. A tracking error is simply the difference between the benchmark’s returns and the ETFs returns. In a well-run, efficient ETF this should simply be the MER. Some other ETFs do a poor job of tracking their Index though, and have much higher tracking errors. Too often, investors focus just on the MER of an ETF but in actuality, they should be focusing on the total tracking error instead. Take Vanguard’s S&P 500 Canadian Dollar Hedged ETF which has an MER of 0.09%. However, its return since inception has been 12.79% vs. the Index return of 13.18% for a total tracking error of 0.39%. Investors looking only at fees may think they are getting a good deal but have not taken into consideration the inefficiencies involved with currency hedging.