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(Yong Hian Lim/Getty Images/iStockphoto)
(Yong Hian Lim/Getty Images/iStockphoto)

ETF basics

What is an ETF and how does it work? Add to ...

An exchange-traded fund (ETF), like a mutual fund, is a type of investment fund. An investment fund is a collection of investments, such as stocksbonds and other funds. Like a stock, an ETF is traded throughout the day on a stock exchange.

3 main types of ETFs

1. Index ETFs

Index ETFs are the most common type of ETF. They hold the same mix of investments as a stock or bond market index. In this way, they mirror, or passively track, the performance of the index. For example, an index ETF may track:

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  • a broad-based index, such as the S&P/TSX Composite Index,
  • a specific sector, such as health care or infrastructure,
  • a commodity, such as gold or oil, or
  • a currency.

If the index or sector that the index ETF tracks does well, so does the ETF. If the index drops, the price of the ETF will also drop. Index ETFs tend to have lower management expense ratios (MERs)than mutual funds.

2. Actively managed ETFs

These ETFs have a portfolio manager who is making investment decisions on what to buy and sell, and when. They usually aim to outperform, rather than passively track, a particular index. These ETFs tend to have higher fees than index ETFs.

3. Leveraged ETFs

These ETFs use leverage (or borrowing) to increase returns. This can be very risky.

Learn more about different types of ETFs and how they work.

Buying and selling ETFs

You buy ETFs in units or shares from an investment firm. Here’s how it works:

  • You can buy or sell ETFs any time the stock market is open. ETFs are traded throughout the day at the current market price.
  • ETFs have ticker symbols, just like stocks.
  • There is no minimum investment amount.
  • The price is closely tied to the ETF’s net asset value (NAV) or the total value of all securities held by the fund.
  • As the value of the ETF’s assets fluctuates, so does the price of the ETF.

Learn more about trading ETFs.

Understanding distributions

Some ETFs pay out the money the ETF makes to investors. These payments are called distributions. For example, you may receive:

  • interest distributions if the ETF invests in bonds,
  • dividend distributions if the ETF invests in stocks that pay dividends, or
  • capital gains distributions if the ETF sells an investment for more than it paid.

Unlike many mutual funds, ETFs do not reinvest your cash distributions in more units or shares. Instead, 1 of 2 things will happen:

  1. The cash will gather in your account until you tell your investment firm how you want to invest it. You may have to pay a sales commission on what you buy.
  2. Your investment firm may offer a program to automatically buy more ETF units or shares for you. You likely won't pay a sales commission on these automatic purchases.

How ETFs are taxed

You'll pay tax on:

  • any capital gains you make from an ETF when you sell it, and
  • any distributions you receive from the ETF.

If you hold an ETF inside a tax-sheltered account such as an RRSP or a RRIF, you won’t pay tax on what you make investing until you take the money out. With a TFSA, you won’t pay any tax on the money you make while it’s in plan or when you take it out. Learn more about how investments are taxed.

Index ETFs are considered to be relatively tax efficient investment funds. This is because index ETFs tend to have less portfolio turnover, which reduces potential taxable capital gains that would be passed on to investors.

Content in this section is provided in partnership with Investor Education Fund, a non-profit organization founded and supported by the Ontario Securities Commission that provides unbiased and independent financial tools to help Canadians make better money decisions. To find out more, go to: GetSmarterAboutMoney.ca

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