The first exchange-traded fund in the world, called TIPS, was launched on the Toronto Stock Exchange in 1990. (Yeah, Canada!) Back then, choosing an ETF was easy because there were so very few. Today, there are thousands of ETFs on the market.
Before you buy, it pays to understand the unique benefits (and risks) of this investment product.
What are the key benefits of ETFs?
- Very low cost
- Trade like a stock
- Wide variety
The primary appeal of ETFs is that investors can build their own portfolios at a low cost. Low management expense ratios (MERs) – usually less than 0.5% per year— are much less than for comparable mutual funds which can charge up to 2-3% in MERs annually. The fact that ETFs trade on an exchange, like a stock, means investors can trade them throughout the day at a low cost by using a discount broker. The incredible variety in ETFs, ranging from traditional stock and bond index funds to commodity and derivative ETFs, means there’s an ETF for almost any investment strategy.
Risk and reward
But ETFs come with risks too:
- Market Risk
- Risk of Impulse Trading
- Liquidity Risk
Every ETF faces the risk related to the market to which the ETF is exposed. Of course, this applies to all investments. However, not all investors take the time to fully understand what particular markets to which an ETF may have exposure. This information can be found on the ETF Fact Sheet. An ETF that tracks the S&P/TSX will earn the same overall return as this index (minus fees and trading costs) and face the same risks as the index. But what about more exotic ETFs like “dynamic beta”? (Whaa?) For these, it’s imperative to read the ETF Fact Sheet to find out about the ETF’s investment strategy, benchmark, portfolio characteristics, top holdings, among other attributes.
What appears to be an advantage of ETFs (easy to trade) also becomes a double-edged sword. During market volatility, the easy access to trading ETFs may lead some investors to panic selling since many ETFs are very liquid. In this case, investors may lose out on the benefits of holding investments over the long term. Always refer to your investment plan to avoid emotionally-driven trading.
Does the ETF you wish to purchase trade regularly and in sufficient volumes? How large is the gap between the bid and ask prices quoted? If the gaps are large, this should ring a warning bell that the ETF is not very liquid and you may not be able to trade in and out as easily as you expect—especially during periods of heightened volatility.
Fact of the matter
There’s no doubt ETFs have changed the investing landscape for the better. Once you’ve identified your investment goals and adopted a relevant investing strategy for achieving them, ETFs are a low-cost way to implement your strategy on your own.
If there’s one piece of advice you take away from this article, it’s: Read the ETF Fact Sheet!