An Introduction to Exchange Traded Funds (ETFs)
Exchange Traded Funds (ETFs) are extremely popular with investors of all types. In recent years, ETFs sales have even outpaced mutual fund sales, making them the fastest growing investment vehicle in both the U.S. and Canada. Despite the growing demand and popularity, many investors still aren’t sure exactly what an ETF is or how they work.
The name ‘Exchange Traded Fund’ is a great place to start since unlike some other investment jargon, it actually provides a useful and straightforward description that can help you understand what it is. First and foremost, an ETF is a type of investment fund. This means it’s an investment product that holds a pool of different investments inside of it. What makes an ETF unique is that the fund is exchange traded, i.e. traded on an exchange like the Toronto Stock Exchange (TSX) or New York Stock Exchange (NYSE).
ETFs differ from other types of investment funds, such as mutual funds or hedge funds, that may hold securities traded on an exchange but the actual fund itself is not traded on the exchange. With an ETF, units of the fund are bought and sold daily on public markets during regular trading hours.
How do ETFs work?
Even though ETFs are pretty easy to understand as a type of investment vehicle, the actual mechanics of how they are created and traded behind the scenes are a little more complex. Here is an overview of the main players and their roles in creating and facilitating the trading of ETFs:
The fund provider
The ETF is created by the fund provider who ‘manufactures’ the investment product. They decide what types of investable assets go into their ETF based on the needs of investors. Let’s say in a theoretical example that the fund provider determines a need for an ETF that exclusively focuses on the telecommunications industry. So, they launch an ETF comprised of telecommunications companies like Bell, Rogers, Telus, Verizon, T-Mobile, etc. They decide on the weighting of each of the companies in the fund and then engage with a market maker who will buy the stocks so the fund provider can create the ETF.
The market maker
The market maker is a large institution with buying power or an inventory of securities. They buy the stocks that the fund provider has outlined will be included in the ETF. So with the example above, they buy stocks of telecommunication companies and then deliver them to the fund provider. The fund provider then can create units of the ETF that investors can buy and sell via the stock exchange that the ETF is listed on.
All sorts of investors buy ETFs, from everyday DIY investors to large institutions or pension funds. For most transactions, the investors are buying units of the ETF from the stock exchange. As the ETF units are purchased, the market maker is ensuring that the price of the ETF is close to the Net Asset Value (NAV) of the underlying securities the ETF holds. If the ETF is trading higher or lower than its NAV, the market maker creates or redeems ETF units so the trading price remains close to the true value of the underlying securities.
What are the benefits of using an ETF?
ETFs have become so popular because they have unique benefits compared to other investment vehicles. Some of those benefits include.
Since ETFs are a type of investment fund that holds a basket of securities, they provide much more diversification than a single stock. Some ETFs are more diversified than others depending on what type of ETF it is.
A unique benefit of ETFs is that they are built to help investors avoid unnecessary capital gains taxes. Many ETFs are built like index funds, so they buy and sell the securities inside their fund less frequently than most actively managed funds, which creates fewer taxable capital gains events for those who hold the ETF.
A world of options
This may come as a surprise to new investors, but there are actually more ETFs than there are stocks in the stock market. With so many ways to dissect the world of investible securities, there are ETFs for almost every type of asset class, investing style, investment theme or anything else an investor could want. And due to their popularity, new ETFs are constantly coming to the market, offering new options for investors of every type.
Which ETFs can I trade?
As far as being a Qtrader, if an ETF is listed on a North American exchange, you can buy it. Just because the ETF is registered on a North American exchange, it doesn’t mean you are limited to North American companies. There are many ETFs available that allow you to invest in equities and fixed income securities from other regions and countries. For example, some ETFs select the biggest global companies, others may focus exclusively on a region like ‘emerging markets’ while others may focus on a specific sector and geography, such as North American real estate.
With Qtrade you also have access to over 100 Canadian and U.S listed ETFs that trade commission-free and with no minimum trade amount. You just have to hold the ETF for a minimum of one business day. See the full list of commission-free ETFs available on our platform.
What are the best ETFs?
There is no “best” ETF as markets shift constantly and the performance of ETFs change accordingly. The best ETF for you is the one that meets your needs and that depends on what type of investor you are. Most investors are looking for a diversified portfolio that meets their risk tolerance.
Asset Allocation ETFs
If you are an investor who wants to keep it simple, you could invest in an asset allocation ETF that is built to be an all-in-one diversified investment portfolio. For example, iShares’ ETF Portfolios (included in our list of commission-free ETFs) are multi-asset solutions designed for an investor who want a low maintenance solution that is also low cost. These products range from the iShares Core Income Balanced ETF Portfolio (XINC) for investors with less risk tolerance and who are more income focused, to iShares Core Equity ETF Portfolio (XEQT) for investors willing to take on more risk and be exclusively equity focused. For a deeper dive on the benefits of Asset Allocation ETFs read, Do the new "ETFs of ETFs" fit into your portfolio?
For many investors, the idea of an “ETF” is synonymous with index investing because many of the largest ETFs are designed to track popular equity indices like the S&P 500, NASDAQ and TSX. There are also ETFs that track fixed income markets like bond and treasury indices. These types of low-cost ETFs are great building blocks for portfolios where investors want to be able to change the weight of different types of assets in their portfolio depending on their investing timeline and risk profile. For more information on asset allocations strategies download our beginner’s guide to investing
The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This material is for informational and educational purposes and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters.