An Exchange Traded Fund (ETF) offers investors a wide exposure to a variety of sectors in many countries. A big attraction is lower costs than traditional mutual funds. On the other hand, investors generally won’t benefit from market outperformance and benchmark indexes can be volatile, raising temptation to increase frequency of buying and selling – and that eats up money in commission fees.
Exchange Traded Funds offer investors a wide exposure to a variety of sectors in many countries. A big attraction is lower costs than traditional mutual funds. On the other hand, investors generally won’t benefit from market outperformance and benchmark indexes can be volatile, raising temptation to increase frequency of buying and selling. And that eats up money in commission fees.
What’s An Exchange Traded Fund
Exchange traded fund (ETF) tracks an underlying index, whether it is based on a basket of commodities, stocks, bonds – or other indexes, such as the S&P/TSX, the S&P 500 or the Nasdaq.
What’s The Attraction For Investors
ETFs have exploded in popularity over the years because they combine the best features of stocks and mutual funds. The units offer wide exposure to a variety of securities and are traded daily on stock markets. However, the annual fees are much lower than standard mutual funds.
Also, there are no front- end or back- end loads (commission fees) for an ETF. Since they are traded like a stock, brokerage commissions are paid at the time of purchase and sale.
Annual fees are lower because a standard equity mutual fund is comprised of a collection of stocks from various companies in a variety of sectors. Investment managers continually fine-tune the holdings in these funds. The extra work is meant to justify higher management expense ratios (MERS), which can easily come in at 2.5% for a Canadian equity mutual fund.
That extra work is also supposed to result in that fund ‘beating the index.’
However, some investors feel that since many managers can’t improve on the index, they may as well put their money in a fund that tracks the index. An ETF is not managed and that means the MER comes in sharply lower, around 0.5% or less.
Valuation
ETFs are traded on stock markets, meaning an investor can simply gauge performance on a daily basis by looking up the unit in question. It’s just like looking up how a stock did.
On the other hand, mutual funds are bought and sold directly through the fund company at the fund’s net asset value (NAV) at the end of each trading day.
ETFs, like most mutual funds, are open-ended, meaning such a fund can issue any number of new shares or redeem existing shares, depending on investor demand.
Double The Fun
Exchange Traded Funds can also offer the opportunity to magnify your gains – or losses.
These are called leveraged ETFs and they use derivatives and debt to potentially double or triple your gains. For example, if an investment in a crude oil ETF went up or down by five per cent in a day, a fund with a 2:1 ratio would be designed to go up or down approximately 10 per cent. Other leveraged ETFs offer a 3:1 ratio. But investment advisers caution these are for only very short-term use and are best left to the professionals.
Tax Treatment
If a Canadian equity ETF investment is in a taxable account (that is, an account other than an RSP or TFSA), dividends are eligible for the dividend tax credit. Capital gains can be deferred and are taxed at half your marginal rate at time of sale.
Weighing The Benefits
On the plus side, ETFs have much lower fees compared to traditional mutual funds and investors can invest in a wide variety of sectors involving markets in different countries.
On the downside, investors generally won’t benefit from market outperformance and benchmark indexes can be volatile, raising temptation to increase frequency of buying and selling. And that eats up money in commission fees.
