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What is an Exchange Traded Fund? (ETF)

An exchange traded fund (ETF) is a fund that trades on an exchange – as such, investors will buy and sell units of the fund from other investors via the TSX or NYSE instead of necessarily going through a financial adviser to buy mutual funds.

An index exchange traded fund is a passive investment fund which seeks to emulate its benchmark index. They replicate the returns of the index by holding what the index holds. Index ETFs have become increasingly popular with huge growth via inflows from older investors who do not believe mutual funds are generating the returns needed to justify their heft fees to do-it-yourself millennials either through brokers or roboadvisers.

The S&P 500 is the most popular index in the world and is considered a good proxy for US stocks in general. Index funds available to Canadians that mirror the S&P 500 include XSP (iShares Core S&P 500 CAD-Hedged), XUS (iShares Core S&P 500), VFV (Vanguard S&P 500 Unhedged). Index funds that emulate the S&P/TSX, Dow Jones Industrial Average and the entire stock market are also available to Canadians.

Advantages to Investing in ETFs

ETFs are open ended funds so units outstanding are not fixed. ETFs have a lot to offer investors as they combine the benefits of diversification, flexibility and cost.

  • Diversification – ETFs, and index ETFs in particular, offer an opportunity to invest in hundreds or thousands of securities at the same time, whereas purchasing one of each stock individually would be prohibitive to most investors due to cost and hassle. Diversification – or not putting all of one’s eggs in one basket – is important for most investors to mitigate risk
  • Flexibility – While investing in many stocks will result in huge broker fees to purchase each one individually, an ETF can be bought and sold as if it were just one stock. Also, they are very liquid, so entering or exiting positions does not come with extensive planning and cost
  • Cost – Index ETFs are extremely low cost, with investing in a large, liquid index fund managed by Blackrock or Vanguard having fees that are just tens of basis points (1/10th of a percent). There is a race to zero for fees – the Blackrocks and Vanguards of the world make money from securities lending – loaning out their stocks to short sellers and charging interest. Since the funds belong to the investors and not the custodians in Blackrock or Vanguard, it is an extraordinary return on capital

However, as investor inflows continue, the ETF market is offering increasingly tailored products – at a higher fee of course. So, if a true mutual fund is active management and an index fund is passive management, investors can get pretty much anything in between. From smart beta to responsible investing, there is something for everyone.

Types of ETFs

In terms of dollar value, the majority of ETFs are held in passive investments – namely Index ETFs.

These are characterized by very low fees and replicate a benchmark by holding its constituents. When there are additions or deletions to an index, the ETF will rebalance. Usually, a good ETF’s returns will trail but be very close to the index for the year.

Popular examples include ETFs customized for:

  • Sector – Instead of getting an entire index that encompasses all sectors of the economy, investors can choose to only select energy or technology stocks because they feel that there will be relative outperformance in making a macro bet instead of one on individual securities. Sector ETFs can also be used to exclude exposure – for instance, in 2015 if someone felt that the market was going to go up but energy stocks would tank because of the falling oil price, they would have done very well by buying the S&P but shorting an Energy Sector S&P Index.
  • Country – Depending on sentiment, investors can bet on China, Argentina or Brazil. The more liquid the market, the lower the fee will be. As an extension, investors can also choose a regional or classification ETF – such as All-Euopre or Emerging Markets.
  • Style – Style is usually segmented into value or growth – do investors want stocks with lower multiples or stocks that have exhibited outsized returns but relatively stretched multiples. Usually this will not be a standalone feature and will be paired with another classification – for example US Mid Cap Growth
  • Size – Investors can invest in large capitalization, mid cap, and small cap companies (or small and mid cap). Depending on views on the macroeconomy and the investor’s risk profile, they may tilt differently
  • Leveraged – These ETFs will lever up to enhance returns – this means that losses are also magnified. This will be paired with some other class, so you can have a China 3X Bull Index, where if Chinese stocks go up by 15%, this ETF will go up by 45% (in reality, something closer to 35% due to the negative carry due to the leverage and rebalancing costs of these ETFs). If Chinese stocks fall by 15%, investors may lose half of their investment. These ETFs are best for short term plays as opposed to longer term bets due to the cost.
  • Ethical – These ETFs started out with environmentally sustainable ETFs where constituents had to meet certain criteria related to pollution (fees are higher) – which usually meant tossing out energy stocks. Today there are all sorts of companies looking to cash in on ETFs and personal philosophy, including Christian anti-abortion ETFs, social impact investments and all sorts of other options

Why an index fund instead of buying stocks or purchasing a mutual fund?

First, we would like to introduce two major financial concepts: alpha and beta exposure.

We do not intend to get into the classroom denotation for these terms for this section, so we will simplify them. Beta exposure is your exposure to the broader stock market benchmark. The benchmark will depend on what securities are in your portfolio – if you have Canadian blue chip, large capitalization stocks, your benchmark is probably the S&P/TSX 60.

Your alpha is your return in excess of the broader stock market due to your security selection and deviance from a portfolio of stocks representing the index.

The reality is that the vast majority of people cannot generate alpha and beat the market. Additionally, if you have the intellectual capacity and thoughtfulness to beat the market and security selection is not your full-time job, the incremental gain from beating the market is essentially your compensation for a minimum wage part-time job on top of your full-time job. Spend the extra time doing something you enjoy or making more money through a business or other part-time job that leverages your core competency (for instance, if you are an engineer you can generate additional income by being a tutor or consultant).

Most mutual funds that are sold by your local financial services representative or account manager at the bank branch do not generate alpha – on top of that active management has its costs, because the fund must cover the branch’s operating costs, the financial services representative’s salary and bonus, the portfolio manager in charge of the fund’s security selection’s team and their salaries. In addition to that, the fund must earn a return for the bank’s shareholders. These costs are paid for by fees, which you will see in the mutual fund’s “Management Expense Ratio” or MER, which can go up to 3%. To justify investing in a mutual fund, there needs to be an assurance that it can consistently beat the market by 3% as a breakeven.

Go to your existing bank and open a trading account (i.e. CIBC Investor’s Edge or TD Waterhouse/Direct Investing) – we recognize that there are discount brokerages (traders prefer Interactive Brokers, which is an outstanding company), but as you are not going to be trading or putting in orders often, it is more convenient to have all your assets consolidated in one place and easy to see for the cost of $8 more per trade (which we envision will get cheaper as well). Additionally, you may find that you may receive better service at the branch as the assets the teller sees will be larger.

What if the market falls?

Provided you are putting in the same amount into the index fund every paystub, you should not care. If anything, you can buy the same assets you were going to buy anyway at a lower price than you bought it for two weeks ago.

This is based on our assumption that the stock market over a long-term horizon will be higher than it is today. This is an assumption that has worked for North American stock markets since their inception. The market will have crashes and corrections along the way, but over a longer period (10-years), it will go up on average by 7-8% a year before distributions (the S&P has a dividend yield of ~2% on top of that).

We note that this strategy only holds if you have a long-term time horizon for investment and will not run into any liquidity needs (hence our cash buffer recommended above).

What index should I buy?

For most investors, it is natural to purchase an ETF that represents their domestic stock market. Canadians purchase the TSX, Australians the ASX and Hong Kongers the Hang Seng Index.

We prefer purchasing US or global indices ahead of the S&P/TSX via major asset managers such as Blackrock or Vanguard.

Theoretically, since a Canadian investor’s assets and income are denominated in Canadian dollars, you should hedge FX exposure (FX is zero sum) so there no major harmful swings in your portfolio. However, we recognize the US dollar exposure of the portfolio is not as volatile as that of an emerging market currency and should move more gently. Also, we are taking a view on US$ appreciation versus the loonie.

We prefer the US because of these factors:

  1. The US stock market has less sector concentration (TSX is heavily oil, mining and financials)
  2. The US is more innovative and business friendly than Canada, and benefits from scale (10x the population) leading to more innovation (when was the last time you heard of a Canadian world beater… Blackberry) and higher corporate profits
  3. Canadians have a large home bias (Canadians overwhelmingly invest in Canadian equities and are to some extent incentivized to do so via dividend tax credits while Canadian equities make up less than 5% of the globally listed market) – and the TSX is likely less correlated with your personal income than the S&P is to most Americans and global citizens

If you choose to invest in US equities, you will first need to buy USD with the CAD in your brokerage account. Currency conversion costs can be substantial (depending on the brokerage you’re using it can be 1.5% of the total amount converted). Luckily, an alternative method called Norbert’s Gambit exists, and it is time tested to be more cost effective than converting through the brokerage.

Related Reading for Investing

Investment Asset Classes

Fixed Income – An introduction to bonds and other fixed income instruments
Index ETFs – An introduction to index ETFs and why they make sense versus most mutual funds
Avoiding Exchange Rate Fees at Banks for Investing and Travel
Real Estate
Taxes – All investors have to deal with taxes but it is important to know how to minimize tax drag on your investments through understanding TFSAs and RRSPs

Commentary on Investing

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