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EXCHANGE-TRADED FUNDS | MODULE 1

EXPLAINING ETFs

Start the ETF course by learning about the basics of ETFs, including the advantages and risks.

WHAT IS AN ETF?
An exchange-traded fund (ETF) is a collection of assets that trades on an exchange. ETFs are a diversified, low cost and tax efficient way to invest.
An ETF is like a basketball team.

AN ETF IS LIKE A “TEAM”

An ETF is like a basketball team.

Consider a basketball team, made up of key players like a point guard, shooting guard, power forward, small forward and center. Together, they can diversify their strengths to win the game. Similarly, an ETF is like a “team” made up of diversified “players” like stocks, bonds and commodities that tracks against the “goal” of matching its performance to an index, such as the S&P 500. In doing so, it potentially provides more predictable returns than other investment choices.

EXPLORE THE ADVANTAGES

1) ETFs diversify investment portfolios and lower risk

By incorporating ETFs within an investment strategy, investors can benefit from instant diversification. ETFs offer greater diversity than simply buying individual stocks because they pool together different assets, such as stocks, bonds and commodities. Financial professionals can help investors reduce the risk in their portfolios and maximize their potential returns through diversifying their investments.

2) ETFs demystify investing

Generally, ETFs are transparent because they show what the underlying investments in the ETF are. This is not always the case, for example in a mutual fund, where the portfolio manager has the discretion to choose not to reveal the investments in the fund.

3) ETFs provide greater access to different markets

ETFs provide access to markets across the globe, ranging from specific countries to an asset class like global bonds – and even commodities like gold. Investing in difficult-to-access markets such as emerging markets becomes much more straight forward by investing in ETFs.

4) ETFs are easy to trade

Part of the appeal of ETFs is their liquidity, which provides the flexibility to turn an investment into ready cash quickly, with no loss in value. In most cases, mutual funds can only be bought or sold once a day at a price established at the market close. ETFs, however, act similarly to stocks so they can be bought or sold anytime during market hours.

One common misconception that investors ask is, “Are ETFs more volatile because they are traded throughout the day?” The answer is simple – no, price changes do not make the investment more volatile, just more visible.

Because ETFs have the same trading flexibility as stocks, short-term traders can use ETFs to quickly move in and out of a position. But ETFs are also a cost-efficient way to build a long-term, core portfolio.

5) A big draw of ETFs is the bottom line—reducing costs

The management fees for most ETFs tend to be much lower than mutual funds, which means more money can be put towards a potential return. As an example, iShares Core ETFs average about one-tenth the net expense ratio of most mutual funds.1 The impact of these cost savings can be meaningful, particularly over time or when market returns are low.

Here’s another potential benefit. ETFs tend to be relatively tax efficient and incur fewer undesirable capital gains distributions, which occurs when an investment appreciates in value and is sold. Reducing the impact of taxes on an investment can help improve the return on an investment.

ETFs are:

ETFs are one-third the price of the average active mutual fund.
the price of the average active mutual fund2
ETFs are half the tax cost of the average active mutual fund
the tax cost of the average active mutual fund3

CONSIDER THE RISKS

All investments come with risk. To put it simply, risk affects the value of an investment. More risk can mean more reward but less certainty around the outcome. Financial professionals should work with their clients to ensure they are aware and comfortable with the levels of risk being taken.

Different types of risks

Capital risk
Capital risk
All investments involve an element of risk. The value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.
Tax risk
Tax risk
International taxes will impact returns. It is important to understand how much ETF returns may be taxed.
Currency risk
Currency risk
ETFs feature some level of currency risks. International ETFs are priced in local currencies, so changes in exchange rate will impact the value of an investment.

Liquidity risk

Low liquidity of an ETF can lead to higher trading costs or difficulty in buying or selling the ETF.

To assess liquidity, consider:
Consider the difference between the buy and sell price of the ETF.
Average bid/ask spreads
This is the difference between the buy and sell price of the ETF. In general, the narrower the spread, the more liquid an ETF is.
The higher the trading volume, the more liquid an ETF is.
Average trading volume
In general, the higher the volume, the more liquid an ETF is.
Consider how close the ETF trades to its NAV.
Whether the ETF is trading close to its NAV
This is an indication of the fair value of each ETF share. The closer it is to its net asset value, the more liquid the ETF is.

REDUCING THE RISK

Risk cannot be eliminated but it can be reduced.

Risk cannot be eliminated completely but it can be reduced. Diversification is one of the key ways in doing so, by spreading investments across different sectors, geographies and asset classes. If one sector or asset is not performing well, other investments can balance out any potential loss. When building an investment portfolio, it is important to consider the impact of risk.

THINK DIFFERENTLY

Investing in ETFs can offer a range of benefits, including simplicity, low cost, transparency, diversification and flexibility. Consider ETFs as a way of accessing the best of mutual funds and individual stocks.

 

This concludes the first module of the ETF course. Read the next module, which compares ETFs to other investment options, to continue the course.

 

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I professionally manage portfolios on behalf of individual investors and provide financial advisory services. Examples of financial professionals include financial advisors, private bankers, etc.

Institutional investor
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Individual investor
I buy and sell securities for my personal account, not for another company or organization. I am not a financial professional nor an institutional investor.