Exchange-Traded Funds (ETFs) have become incredibly popular in Canada in recent years.
You might have heard of ETFs being an excellent alternative to investing in mutual funds, due to its lower fees.
Let’s dive deeper and find out what it is exactly.
What Is An ETF In Canada?
Canada is known for its innovation for several things, like insulin, ice hockey, and poutine. Our country has also played a pivotal role in the investment world through its pioneering efforts in creating modern-day ETFs during the 90s.
An Exchange-Traded Fund, as its name suggests, is a fund that you can trade on a stock exchange, similar to how you trade stocks. Unlike stocks, ETFs are investment funds that invest in a group of securities like stocks and bonds.
The value of an ETF on the stock market typically represents the value of the basket of underlying securities held by the fund.
Understanding how ETFs work is remarkably simple. An ETF issuer or fund manager handles the task of studying the universe of securities, including stocks, bonds, currencies, commodities, real estate, international markets, and creates groups of their top picks based on particular investment goals.
These groups could be thematic, like “the best gold producers,” “top healthcare companies,” “best energy companies,” or they could simply track a particular industry, like the energy or health care sector. Once the fund issuer creates their basket of investments, they sell shares of the bundle to the public.
When you purchase the shares of an ETF, you do not own the underlying assets held by the fund. Instead, you own a share of the basket itself. Your investment returns will be based on the performance of the basket.
When the basket of securities goes on a strong bull run, you and everybody else who has invested in the ETF will get investment returns based on how many shares you own.
If you want to buy or sell your ETF, it is a matter of trading it on the stock exchange, similar to how you would buy or sell individual stocks.
Types Of ETFs In Canada
Canadian ETF issuers manage 964 ETFs, boasting a total Assets Under Management (AUM) of $338.5 billion as of November 30, 2021, and the numbers keep growing.
ETFs cover a wide range of asset classes and track a variety of investments that make them a convenient method to derive investment returns based on your preference.
This section of my guide to what is an ETF in Canada will cover the major asset classes and investment products in the biggest ETF categories.
1) Index ETFs
The TSX boasts funds that replicate the performance of specific stock market or bond market indices. These funds are an attractive type for individual investors because they allow you to invest in a group of stocks based on a market index without individually purchasing stock as held in the different indices.
Suppose that you want to own a stake in the performance of America’s economy. In that case, you should consider investing in ETFs that track the performance of the S&P 500 Index. The index tracks the performance of 500 publicly-traded companies in America with the highest market capitalizations.
You can also choose to diversify your investment capital across smaller companies through ETFs that track indices like the Russel 2000 or S&P 400, which track the small-cap and mid-cap publicly-traded companies, respectively.
2) Industry Tracking ETFs
These funds include major sectors of the economy or the segments of the market that represent certain industries, such as financials, health care, technology, energy, or more.
3) Commodity ETFs
Commodity ETFs track the performance of securities related to various commodities, like oil or gold. These funds invest in baskets of companies with business operations related to the underlying commodity or the price performance of the physical commodity itself.
4) Thematic Or Specialty ETFs
Thematic ETFs comprise funds that invest in a basket of securities based on a theme. Specialty funds may be more complex ETFs that could include leveraged funds, inversed funds, or other atypical ETFs.
5) Leveraged ETFs
Leveraged ETFs rely on using derivatives to achieve the daily returns of the underlying asset that are then multiplied by two or three. These are higher-risk investment vehicles that are designed to magnify gains, but they could also enhance any potential losses.
6) Currency ETFs
Currency ETFs are funds that invest in individual currencies or baskets of currencies from particular regions worldwide to provide you with investment returns based on their performance.
7) Real Estate ETFs
Real Estate ETFs are funds that invest in groups of Real Estate Investment Trusts (REITs) to provide you with investment returns based on their performances.
ETFs offer a wide range of benefits that have made them popular over the years. This section of my guide to what is an ETF in Canada will cover three of the most impressive advantages of investing in ETFs.
ETFs provide you with reduced capital risk by diversifying your exposure to various asset classes.
If you are new to investing or don’t have the time to manage a self-directed portfolio of stocks and other securities yourself, investing in ETFs offers you a hands-free approach to investing in a diversified portfolio of securities.
2) Tax-Related Advantages
Everybody pays taxes on capital gains, and there is no way around it. However, ETFs are far more tax-efficient than mutual fund products.
Mutual fund managers typically trade underlying investments frequently, creating tax liabilities for the fund’s unitholders. ETFs tracking indices don’t change underlying investments too often. It means that you end up paying capital gains taxes only when you sell the fund.
3) Time Efficiency
Creating a self-directed group of securities requires conducting extensive research and potentially making hundreds of individual trades to acquire everything.
Suppose that you are trying to invest in the S&P 500. Creating a self-directed portfolio would mean doing your due diligence on 500 different equity securities and buying them.
Buying an ETF that tracks the S&P 500 Index means that the fund manager has already done all the hard work and compiled the group of 500 securities into one simple package.
4) Low Fees
Compared to mutual funds, ETFs are on average much, much cheaper to purchase. Fees are one of the biggest determinates of how a fund will perform long-term, and its come under investors’ scrutiny in recent years. With ETFs, you can construct portfolios for as low as 0.10% – 0.20% per year, which is extremely cheap.
ETFs offer you the opportunity to enjoy mitigated capital risk by diversifying your capital, they offer tax advantages, and you can make more timely trading decisions with these funds. However, they do come with a few drawbacks that you should know.
This section of my guide will cover the three significant disadvantages of investing in ETFs.
1) You Won’t Outperform the Markets
With a passive ETF investing strategy, you’ll usually perform at right around the market return. For many people, this is not a great story. Everybody wants to “beat the market.” However, it’s clear that active management does not beat the market on average over the long term due to its high fees, so I don’t think that this is truly a disadvantage.
2) ETFs Carry Inherent Risks
Investing in an ETF carries far less capital risk than investing in individual stocks. However, that does not mean that ETFs do not entail any risk. You can still lose the money invested in a diversified basket of securities during volatile market conditions.
Some ETFs can perform better than others, while others perform poorly. If investors sell too many shares of the fund rapidly, it could cause the ETF to become bankrupt. Investing in an ETF also requires understanding the risks it entails, focusing on long-term gains.
3) ETFs Are Easy To Liquidate
You can trade ETFs like stocks during the day on a stock exchange. The flexibility is an advantage for investors who want to capture quick profits. But it is a double-edged sword because you can easily liquidate your shares in an ETF due to irrational fears.
The time efficiency of trading ETFs comes with the drawback that you can sell your units too quickly and miss out on potential capital gains.
By definition, ETFs seem eerily similar to mutual funds. ETFs and mutual funds are pools of investments that are managed by professional fund managers. The two investment vehicles let you diversify your capital across a wide range of asset classes.
You can use both of them as core holdings to get long-term investment returns. However, you cannot buy and sell mutual funds during the day like you can with ETFs.
You can only buy and sell mutual funds at the end of the day, and switching investments takes two more days beyond the day when you trade the mutual fund.
ETFs have become popular in recent years as an alternative to mutual funds. According to the Canadian ETF Association (CETFA), the ETF market growth year over year as of November 30, 2021, has been a remarkable 35.6%.
ETFs offer several advantages over mutual funds, and there are several reasons why mutual funds are awful that make ETFs a better alternative.
Owning an ETF means that you also have to cover the cost of operating expenses that can include the fund managers’ fees. The expense ratio is a percentage that expresses how much it costs for you to own the fund. The fund deducts the operating expenses from your account value each year.
Some actively-managed ETFs can entail higher expense ratios than others, making them expensive to own. However, investing in an ETF with a long buy-and-hold view makes the cost insignificant. But constantly buying and selling ETFs could see these operating expenses pile up into a significant amount.
What Is A Good ETF To Invest In Canada?
There are over 900 ETFs on the market today and many of them with drastically different mandates. It can be helpful for you to distill the list of funds into something that aligns well with your investment objectives and interests.
Check out my guide to the best ETFs in Canada for a narrowed-down list of some of the top ETFs in Canada classified across eight categories.
How To Buy ETFs In Canada
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The right knowledge on what ETFs in Canada are, how they work, their advantages and drawbacks, and a list of some of the top funds you can consider is a good way to go if you are considering dipping your feet in the ETF investing world.
My favorite way to invest in ETFs in Canada is by using trading platforms. Check out my guide to the best trading platforms in Canada to review your options and understand how you can use them to begin ETF investing in Canada.