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With the end of tax-free switching in corporate class funds, Total Return Index ETFs offer an alternative. (iStockphoto)
With the end of tax-free switching in corporate class funds, Total Return Index ETFs offer an alternative. (iStockphoto)

EXCHANGE-TRADED FUNDS

The basics of ETFs, and why most investors should be buying them Add to ...

Exchange-traded funds have taken the investing world by storm. A hybrid between a mutual fund and a stock, they have grown in popularity since the world’s first ETF was listed on the Toronto Stock Exchange in 1990.

Today they account for more than $107-billion in assets in Canada, according to data from the Canadian ETF Association, and their popularity is growing.

Investors are turning to them for good reason. In fact, here are eight good reasons to give ETFs a try.

Buy and hold on the cheap

ETF management fees are a small fraction of those charged for similar mutual funds. “It’s now possible to buy ETFs that track the broad Canadian and U.S. stock markets for as little as 0.05 per cent, which is just $5 a year on every $10,000 invested,” says Dan Bortolotti, an associate portfolio manager with PWL Capital in Toronto.

Compare that to a Canadian equity mutual fund charging 2 per cent a year, and you’re already ahead $195 annually. Over 20 years, you would save almost $7,000 in fees. Moreover, you can buy ETFs through a discount brokerage for about $10 per trade. Some online brokers – Questrade, for example – even offer ETF trades for free.

Diversification made easy

Like mutual funds, ETFs are a great way to diversify your money but at a lower cost. Offering baskets of stocks, bonds and other securities in one fell swoop – often across many sectors and markets – ETFs largely make holding individual stocks and bonds obsolete, says portfolio manager Tyler Mordy, president of Forstrong Global Asset Management in Toronto.

“How many times have you heard that an investor had the correct outlook for a sector or investment class, but individual company risk produced a poor outcome?” he says. “ETFs help to mitigate this risk.”

Lucratively liquid

Most ETFs are highly liquid investments. Because they are traded on stock exchanges, you can buy and sell ETFs quickly and easily while incurring minimum commission costs.

Moreover, you clearly know exactly how much you’re paying to purchase an ETF and what price you will receive when you sell, says Alan Fustey, portfolio manager with Index Wealth Management in Winnipeg.

“This contrasts with the process for transacting in traditional mutual funds, where pricing occurs after the close of market trading and requires an order to be placed by an investor in advance of knowing specific transaction prices,” he points out.

Some more complicated ETFs, however, do not offer as much liquidity and may carry higher risk than simple index-tracking ETFs.

Returns

Plenty of research shows that actively managed mutual funds often lag behind their benchmark indices, the ones that ETFs track. Among the research is the S&P’s SPIVA Canada Scorecard, an annual report tracking performance of active managers. Its findings over the past five years, ending in 2015, reveal that only about one-third of active managers in large-cap Canadian equity mutual funds outperformed the benchmark, the S&P TSX Composite Index. And for the U.S. stock market, only about 1 per cent outperformed the S&P 500 over that span.

Tidy taxation

ETFs are generally more tax efficient than mutual funds because they mostly track passive benchmark indices, and managers make fewer trades that could trigger taxable capital gains, says Mark Yamada, president of Toronto-based investment firm PUR Investing Inc.

In contrast, active mutual funds may involve trading to rebalance or shift strategies, resulting in more frequent and potentially larger realized taxable gains. “These accrue to unit holders, who must pay tax even if they did not trade their fund units during the tax period,” Mr. Yamada says, adding this is only a concern with taxable accounts, not registered retirement savings plans, registered education savings plans and tax-free savings accounts.

Travel the world on a budget

ETFs allow investors to tap into global markets they otherwise wouldn’t be able to access through individual securities. Mutual funds offer this advantage, too, but ETFs do it for less. Mr. Mordy says this is particularly advantageous for fixed-income investors because they can invest inexpensively in global bond markets.

“In many cases, real returns from traditional bonds [those available in North America] no longer provide reasonable value or necessary return prospects,” he says. “But ETFs offer income opportunities from around the world” that investors would otherwise have difficulty accessing.

What’s in your mutual fund?

ETFs are lauded for transparency because, as passive investments that mirror the performance of a benchmark index, you get relative clarity regarding which investments the ETF holds, and in what percentage, at any given time. For example an ETF tracking the S&P/TSX Composite Index will have the same makeup of companies listed on the exchange. In contrast, mutual funds usually list their top holdings, and that list may be updated only every three months.

“Traditional index-tracking ETFs simply hold all, or substantially all, of the stocks in a popular benchmark, and they publish their holdings on their websites every day,” Mr. Bortolotti says. “So investors always know what they’ve got in their portfolios.”

Effortlessly understand performance

Because they’re traded on markets, you know their price all the time, allowing you to track performance. What’s more is most well-established ETFs passively track major indices so they closely mirror the performance of their benchmarks, Mr. Bortolotti says. “You should expect them to perform in line with their benchmarks, minus fees,” he says.

If the ETF has a fee of 0.1 per cent and the index returns 7 per cent, your return on the ETF should be very close to 6.9 per cent. “This means you’ll never be surprised by a fund that performs poorly.”

Opportunities abound, wrapped up in one package

Because ETFs offer all of the aforementioned advantages – all in one investment – they are becoming the go-to option for savvy investors, including institutional money managers. A recent study by the ETF company BlackRock Inc. found about 43 per cent of U.S. institutional money managers invest 10 per cent or more of their assets in ETFs.

Because of their growing popularity, ETF firms are rolling out a growing number of options. “The game-changing benefit of ETFs lies in the sheer breadth of content now available,” Mr. Mordy says. “ETFs have colonized virtually every asset class globally.”

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