How do ETFs work best for you? The top funds track an established index and keep fees low
How do ETFs work? It all begins with the concept of indexing. Without indexing, ETFs would not exist. When you hear the word “index,” it’s referring to a sample of the market that represents a statistical measure of the market as a whole.
Investment professionals have used indexing for decades, but it wasn’t until famed investor, John Bogle created the first index mutual funds in 1975, that everyday investors had access to index-based investments.
How do ETFs work? The origin story
The first ETF traded in 1989. It was called Index Participation Shares (IPS). The IPS was an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. Because this product was so new and misunderstood, a lawsuit was filed by the Chicago Mercantile Exchange to stop the sale of IPS in the U.S.
In 1990, ETFs were introduced in Canada. The first was called Toronto Index Participation Shares, and started trading on the Toronto Stock Exchange (TSE). The shares, which tracked the TSE 35 index and later the TSE 100 index, became very popular. It was this popularity that was the catalyst for U.S.-based markets to allow index funds. By 1993, the U.S. Securities and Exchange Commission (SEC) allowed the sales of ETFs by U.S. exchanges.
It wasn’t until the last decade that ETFs really caught the attention of the investment market. At the same time, if it wasn’t for the popularity of index mutual funds and other index based investments, we might have missed the evolution of exchange traded funds.
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How do ETFs work?
ETFs trade on stock exchanges, just like stocks. Prices are quoted in newspaper stock tables and online. You’ll have to pay brokerage commissions to buy and sell ETFs.
Investors can buy or sell ETFs during normal trading hours and they can also put stops or limits on their investments.
How do ETFs work?
The MERs are generally much lower on ETFs than on conventional mutual funds. That’s because most ETFs take a passive management style, or a simpler approach to investing. Instead of actively managing unitholders’ investments, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.
As well, shares are only added or removed when the underlying index changes. As a result of this low turnover, you won’t incur the regular capital-gains tax bills generated by the yearly distributions most conventional mutual funds pay out to unitholders.
How do ETFs work?
As mentioned, ETFs practice “passive” fund management, in contrast to the “active” management that conventional mutual funds provide at much higher costs. Traditional ETFs stick with this passive management—they follow the lead of the sponsor of the index (for example, Standard & Poors). Sponsors of stock indexes do from time to time change the stocks that make up the index, but generally only when the market weighting of stocks change. They don’t attempt to pick and choose which stocks they think have the best prospects.
This traditional, passive style also keeps turnover very low, and that in turn keeps trading costs for your ETF investment down.
How do ETFs work for portfolios over the long-term?
If you want to buy the best ETFs for your portfolio, then you should consider these factors:
Consider buying ETFs in a lump sum rather than periodic small amounts in order to cut down on brokerage fees.
Determine if the ETFs you’re buying will include capital gains distributions.
Know the economic stability of countries when investing in international ETFs.
Understand the liquidity of ETFs you invest in.
Understand how broad the fund is, so you can determine its volatility. The broader the ETF, the less volatility it will likely have.
In our view, the big advantage of Canadian ETFs is that they can help you avoid the risk of choosing a mutual fund with a management style that virtually guarantees below-average long-term performance.
ETFs have gained popularity in the last decade, but they’ve been around for almost 30 years. Did you invest in them early on?
What characteristic made those early, “passive” ETFs attractive?
Comments
Bill
It is well worth your while also to check out “F-Series” managed mutual funds as the after tax costs are very very competitive with ETFs ..One advantage for ETFs is that you can use a “sector” ETF to get exposure to a part of the market in which you ae not familiar enough with individual companies and their stocks — for example the Health Care sector.
Thanks, Bill. We generally prefer ETFs to mutual funds, in large part because of the much lower fees for investors. Still, we find that there is usually an ETF similar to any mutual fund on the market. We continue to recommend passive vs actively managed funds.
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It is well worth your while also to check out “F-Series” managed mutual funds as the after tax costs are very very competitive with ETFs ..One advantage for ETFs is that you can use a “sector” ETF to get exposure to a part of the market in which you ae not familiar enough with individual companies and their stocks — for example the Health Care sector.
Thanks, Bill. We generally prefer ETFs to mutual funds, in large part because of the much lower fees for investors. Still, we find that there is usually an ETF similar to any mutual fund on the market. We continue to recommend passive vs actively managed funds.