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There are 1,381 exchange-traded funds listed on the Toronto Stock Exchange, up from exactly two when I began writing about them as an investment reporter.

I used to put a lot of explanatory content into my coverage of ETFs, but gradually pulled back as they achieved mass popularity by attracting billions from both retail and institutional investors. A reader reminded me the other day that there are still many investors who are new to this way of investing. Her request: can you explain ETFs to me?

Here goes. An ETF is like a mutual fund in that it offers investors a way to buy a portfolio of stocks, bonds or both in a single purchase. Instant diversification, in other words. ETFs are bought and sold like stocks, which means you need an account at an online broker or trading app. You can buy one ETF share, seven, 58, 100, 505 or whatever. It’s up to you to decide how much to invest based on the amount of money you have, the price per share of the ETF and brokerage trading commissions, if any.

ETFs have exploded in popularity in the past decade or two because they’re so cheap to own. The cost of investing in ETFs and mutual funds is measured through the management expense ratio, which is the fees associated with running a fund expressed as a percentage of assets. There are ETFs tracking the S&P/TSX composite index with an MER of 0.06 per cent, while Canadian equity mutual funds might charge 1.5 to 2 per cent or more.

Gross returns from ETFs and mutual funds are reduced by the MER to produce the net returns that are shown in fund profiles and reported to investors. Now you see why the cheapness of ETFs matter so much.

ETFs are low-cost, and transparent. The best and cheapest of them follow all the major Canadian, U.S. and international stock and bond indexes. Buy an S&P 500 ETF and you own a little bit of all the stocks in that index, including tech giants like Microsoft Corp., Apple, NVIDIA and Amazon.

Tracking indexes is called passive investing – active investing is when a portfolio manager chooses individual stocks and bonds. It’s brutally hard for an active manager to outperform the index over the long term, but some have done it. Problem is, past performance is a weak indicator of future returns.

For a model of how to build a cheap portfolio with four funds, check out the Freedom 0.08 ETF Portfolio. Bonds plus Canadian, U.S. and international stocks are included, and the aggregate MER is just 0.08 per cent. That’s 8 cents in fees for every $100 invested.

If you’re willing to pay marginally more in fees in exchange for convenience, consider an asset allocation ETF. Each of these funds contains a mix of stock and bond ETFs tuned to a specific risk level – conservative, balanced, growth and hypergrowth based on all stocks and no bonds. MERs are typically in the 0.2 to 0.25 per cent range.

To keep its momentum going, the ETF industry is producing a torrent of new products. A lot of these funds are based on trendiness and sales potential, not their potential contribution to long-term investor success. A few general rules for picking ETFs in today’s crowded market:

  • Look for a track record of at least three years and preferably five or more: You want to see how a fund has performed in the highs and lows of the past several years.
  • Focus on funds tracking the most recognized indexes for the core of your portfolio: They’re the cheapest, best established funds.
  • Focus on fees: Compare the MER to similar funds, and consider the trading expense ratio, or TER, as well. The TER, shown in ETF Facts documents, shows the cost to the fund of trading the securities it holds. MER+TER = the total cost of owning a fund.
  • Check returns: Crucial when considering funds that veer away from mirroring an index. Are you getting returns to justify the inevitably higher costs?

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