What is an ETF?
An ETF is an exchange-traded fund. Think of it as a mutual fund that trades like a stock. (ETFs) are an easy-to-use, low-cost way to invest your money. An ETF can provide you with access to a diversified portfolio of stocks or bonds in a single investment that trades just like a stock. These low-cost funds typically have extremely attractive expense ratios, and they bring tax benefits compared to traditional mutual funds. In many cases, ETFs track indexes that result in minimal asset turnover and greater portfolio stability.
Why invest with ETF?
- Diversification: There are hundreds of ETFs available, and they cover every major index (those issued by Dow Jones, S&P, Nasdaq) and sector of the equities market (large caps, small caps, growth, value). There are international ETFs, regional ETFs (Europe, Pacific Rim, emerging markets) and country-specific ETFs (Japan, Australia, U.K.). Specialized ETFs cover specific industries (technology, biotech, energy) and market niches (REITs, gold).
- No investment minimums: While mutual funds may often have minimums as high as $1,000, $5,000, or more, ETFs can be bought or sold in as little as one-share increments.
- Option and short-selling opportunities: Because ETFs are traded on a securities exchange throughout the day, the opportunities for option and short-selling exist.
- Lower taxes: Actively-managed mutual funds are subject to much higher turnover than ETFs. Therefore, tax gain distributions are much more frequent with mutual funds.
Holding ETFs in a tax-exempt retirement account is a good way of lowering expenses over the long term.
- More trading flexibility: Mutual funds are only priced once per day, at the close of the market. Conversely, ETFs are priced throughout the day and can be bought and sold on the exchange.
- More transparency: ETFs are completely transparent. Investors can see exactly which securities are held in each ETF. Actively-managed mutual funds do not provide holdings to their investors.
Advantages of ETFs over Individual Stocks
ETFs have the same basic advantage that mutual funds do when compared to picking individual stocks: diversification. And that’s exactly what every investor needs. Over the long run, diversification reduces risk without impacting returns.
A better strategy would be to buy an ETF that tracks the sector’s index. This way, you’re protected against the volatility that a few companies within the sector may be subject to. Further, you’re only making one transaction, instead of several, saving you on brokerage fees.
Advantages of ETFs over Actively-Managed Mutual Funds
It turns out that mutual fund managers are not that different from the average investor: most of them do not beat the market. The fact that most ETFs are indexed, therefore, ensures that they will on average perform better than actively-managed mutual funds. Additionally, there are several other ways in which exchange-traded funds beat out mutual funds.
Expense ratios for ETFs are much lower: Actively-managed mutual funds incur a management fee that can sometimes be more than 2.00% while ETF expense ratios are typically in the 0..05% – 0.75% range
How to Minimize Costs for trading ETFs
Whether you are an active trader or barely touch your portfolio, there are practical ways you can reduce the cost of your ETF exposure. High-frequency traders should focus on the indirect costs of trading – namely, the tracking error and bid/ask spread
- Choose Brokerage account that you can trade ETF for Free. I use Questrade and Wealthsimple for Canadians investors. Etrade, TD Ameritrade, Charles Schwab, Fidelity, Vanguard for US investors.
- Trade ETF under a Tax sheltered account. Use TFSA, RRSP for Canadians. Roth IRA and Roth 401(k) for US investors.
- Choose ETFs that has lower MER. Between .05% to .40% is a good low MER. Some active ETF is trading higher than that.
How to Invest in ETFs: A Step-by-Step Guide
Step 1: Get a brokerage account
For Canadians: I recommend Questrade due to free ETF trade.
For US: Robinhood, Etrade, TD Ameritrade, Charles Schwab, Fidelity, Vanguard
Step 2: Screen ETFs
Focus on Fees: With thousands of ETFs out there, you’ll find plenty of options to choose from. One way to distinguish strong prospects from also-rans is to look at their relative costs. Each exchange-traded fund publishes an annual expense ratio, which represents the percentage of total fund assets that goes toward covering the costs that the ETF incurs every year. Smaller expense ratios mean more money staying in your pocket, and the biggest and most efficient ETF providers have expense ratios for their funds that can be less than 0.1%
For Dividend / Income investors Yield is something we looked at. Around 5% is a pretty good yield. Anything more than that can be too risky. For me, I will go under 5% for the growth ETFs that usually have total yearly returns above 10%.
Performance: I personally looked for ETFs performance. I checked Year by Year performance. I also compare it to major indexes such as TSX, S&P 500.
Holdings: I checked the holdings and weight
Step 3: Build your ETF portfolio
There is a different strategy for ETF investing. Some are focus only on Index ETFs. Some investor focuses on growth. Some investor focuses on Income. I like to combine Growth and Income strategy into my ETF portfolios spread into different countries and sectors.
Incorporating different asset classes, such as stocks, bonds, real estate, and alternative investments, can be a good starting point. Within each asset class, broadening your exposure is also a good idea. For instance, with stocks, having different ETFs that have companies of different sizes, different geographical exposure, and different sector and industry presence will go a long way toward balancing out your portfolio’s risk.
Here is a sample ETF portfolio
Canadian Focus ETFs
- Canadian Index – (XIC.TO) iShares Core S&P/TSX Capped Compost ETF
- Canadian Dividend – (XDV.TO) iShares Canadian Select Dividend Index
- Canadian Mix – (VBAL.TO) Vanguard Balanced ETF Portfolio
- Mix ETFs – Wealthsimple Robo-advisor
- REITS – RIT.TO First Asset Canadian REIT ETF Comm
- Tech – XIT iShares S&P/TSX Capped Information Technology
- REITS – iShares S&P/TSX Capped REIT ETF (XRE.TO)
US Focus ETFs
- US Index (XUU.TO) iShares Core S&P US Total Market ETF
- US Dividend (XDU.TO) iShares Core MSCI US Quality Div ETF
- International Index – (CIE.TO) iShares International Fundamental Index ETF
- Internation Dividend – CYH.TO iShares Global Monthly Dividend Index ETF (CAD-Hedged)
Conclusion on ETF
Exchange-traded funds can be a valuable building block toward putting together a long-term investment portfolio that will bring you growth and income.
Through a combination of low-cost ETFs, smart trading strategies and a clearly defined time horizon, investors can minimize the impact of cost on their portfolio and raise the chances of being happy with your ETF portfolio years into the future.