What are ETFs?

Exchange Traded Funds are just what the name implies: investment funds that trade on an exchange; think of them as a type of mutual fund, but with lower management fees.

Those lower management fees result from the way an ETF is structured. Rather than having a group of managers actively researching and choosing stocks to try and beat the market (which is the model for most mutual funds), ETFs track benchmark stock indexes, such as the S&P 500 or the S&P/TSX Composite, to produce a return equal to the market.

With an ETF, the stock-picking is handled by a sophisticated computer program, so the expenses are lower. You could easily pay a management expense ratio (MER) of 2.40% on a U.S. equity fund, or you could pay a 0.24% MER on an ETF that tracks the performance of the S&P 500.

The original idea behind the ETF was to provide low-cost exposure to recognized indexes. But now there are a host of new and exotic ETFs—one even tracks the performance of social media stocks.

Who should invest in them?

The biggest selling point for ETFs is low cost. Generally, the lower the fees you pay on your investments, the more returns you keep.

Suppose, for example, your wealth manager has allocated $100,000 to be invested in U.S. large cap stocks. That money could go into a mutual fund charging 2.50% per annum, or in an S&P 500 Index Fund, for example, that charges less than half a percent.

If your advisor’s goal is to gain exposure, as opposed to outperforming by a wide margin, this can be the right instrument.

For the sake of easy math, let’s assume the S&P 500 posts a return of zero percent, and you still have your $100,000 in principal investment.

If the mutual fund’s performance matches the index, you’d pay $2,500 in management fees. The ETF performance also would match the index, since it tracks it by design, but your fees would be just $240 for the year.

Bear in mind you’ll face trading commissions on the ETF, but if you’re using a buy-and-hold strategy, you’re looking at a one-time cost.

Do you need professional help?

Like all investments, ETFs require some understanding of the market if you want to go it alone. If you’re looking to invest in a relatively straightforward index, then you may want to make this investment on your own. But, if you do, make sure your advisor knows about it, since the risks and performance of that investment has to balance against the rest of your portfolio.

There also are a large number of ETFs that operate well beyond the standard indexes, including hedge-fund-style strategies, commodity and currency exposure, and leveraged and inverse exposure. You may want professional advice before you bet the farm on whether the spread between the price of gold and silver will widen or narrow.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.