An exchange-traded fund (ETF) holds a collection of investments, such as stocks or bonds owned by a group of investors and managed by a professional money manager. ETFs trade on a stock exchange. When you invest in an ETF, you do not own the actual securities (i.e., stocks, bonds), but you do own shares in the fund.
ETFs are frequently compared to mutual funds. Both ETFs and mutual funds are ways to invest in a collection of investments and diversify a portfolio. But they’re built, bought and sold differently. ETFs are available from an investment dealer or through online trading platforms.
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How do ETFs make money for investors?
ETFs are funds traded on a stock exchange. Their prices will fluctuate throughout the day, like stocks do.
You can make money from ETFs by trading them. And some ETFs pay out the money the ETF makes to investors. These payments are called distributions. For example, you may receive:
- Interest distributions if the ETF invests in bonds.
- Dividend distributions if the ETF invests in stocks that pay dividends.
- Capital gains distributions if the ETF sells an investment for more than it paid.
Unlike many mutual funds, ETFs do not reinvest your cash distributions in more units or shares. What happens with your distributions is:
1. The cash stays in your account until you tell your investment firm how you want to invest it. You may have to pay a sales commission on what you buy.
2. Your investment firm may offer a program to automatically buy more ETF units or shares for you. You likely won’t pay a sales commission on these automatic purchases.
Watch our video: What is an ETF?
Why do some investors choose ETFs?
There are several reasons why you might want to invest in an ETF including:
1. Diversification
When you buy a share or unit of an ETF, you’re investing in a portfolio that holds several different stocks or other investments. This diversification may help smooth out the ups and downs of investing. You can also spread your money among ETFs that cover various investments, such as bonds or commodities. This allows you to further diversify.
2. Passive management
Most ETFs are designed to track an index, such as the S&P/TSX 60. This is called passive investing. Passive investing tends to cost the consumer less compared to active investing. That’s when a portfolio manager actively buys and sells securities to try to outperform the market. There are advantages to active strategies, but passive strategies can outperform active investing based on cost savings alone.
3. Transparency
Most ETFs publish their holdings every day. You can see what investments your ETF holds, their relative weighting in the fund and if the fund has changed its position in any particular investment. This transparency can help you tell if an ETF is meeting its investment objectives. You can usually find out what investments an ETF holds, and their relative weighting in the ETF, on a more frequent basis than for mutual funds, which only disclose their holdings periodically.
4. Ease of buying and selling
You can buy and sell ETFs from an investment firm or online brokerage at any time when the stock exchange is open, at the current market price at the time of the transaction. Like stocks, ETFs are traded throughout the day at the current market price. You’ll usually pay a commission when you buy or sell an ETF.
Unlike a mutual fund, which is only priced at the end of the trading day, ETFs are traded throughout the day at the current market price. You can find the current market price for ETFs at any time, while mutual fund prices are usually only available once daily.
5. Low cost to own
You may pay less to own an ETF than a mutual fund, depending on the fund you buy. Index ETFs, for example, simply track an index, so the portfolio manager doesn’t actively manage the fund, which can mean a lower management expense ratio (MER).
Actively managed ETFs and leveraged ETFs have higher MERs than index ETFs, but may have lower MERs than actively managed mutual funds.
What kind of fees do ETFs have?
Most ETFs have fees that are lower than a typical mutual fund but cost more compared to owning a stock. There are 2 main types of ETF fees:
1. Trading commissions – Like a stock, you will usually pay a commission to the investment firm every time you buy or sell an ETF. Consider how these costs will affect your returns if you’re planning to make frequent purchases or trade often.
2. Management fees and operating expenses – Like a mutual fund, ETFs pay management fees and operating expenses. This is called the management expense ratio (or MER). MERs for ETFs are usually lower than those for mutual funds in the same class. They are paid by the fund and are expressed as an annual percentage of the total value of the fund. While you don’t pay these expenses directly, they affect you because they reduce the fund’s returns. This can add up over time.
You pay commissions to buy and sell ETFs, so if you plan to trade frequently, these costs will impact your return. You will also pay management expenses regardless of how the fund performs, even if the fund has negative returns.
Before you invest, read the ETF’s prospectus or its summary disclosure document to understand the fees. You can find these documents on the ETF manager’s website.
Visit our ETF facts interactive sample to see the information you should know before you invest. You can compare fees and performance online at websites like Globefund and Morningstar.
What kind of taxes will you pay on ETF investments?
When you invest in ETFs, you’ll pay tax on:
- any capital gains you make from an ETF when you sell it.
- any distributions you receive from the ETF.
If you hold an ETF inside a tax-sheltered account such as an RRSP or a RRIF, you won’t pay tax until you take the money out. With a TFSA, you won’t pay any tax while it’s in a plan or when you take it out. Learn more about how investments are taxed.
Because ETFs are traded on stock exchanges, this means their performance will rise and fall along with the stock market. Learn more about how the stock market works.
What are the risks of investing in ETFs?
The level of risk and return of a specific ETF depends on the type of fund and what it invests in. Risks can include:
1. The trading price of units or shares can vary – Units or shares may trade in the market at a premium or discount to their net asset value (NAV) because of market supply and demand. The premiums and discounts for specific ETFs vary, depending on the type of ETF and time period.
2. Concentration can lead to volatility – If an ETF is heavily invested in only a few investments or types of investments, it may be more volatile over short periods of time than a more broadly diversified ETF.
3. There may not be an active market – Although an ETF may be listed on an exchange, there is no guarantee that investors will buy its units or shares. That means you may not be able to sell your ETF when you want to. An active market may not develop or be sustained for the ETF.
4. Some have no benchmark – Some ETFs are indexed, which means it is easier to track their performance against a benchmark. However, this is not true of all ETFs. Active ETFs, for example, may not be designed to track an index so it’s hard to compare performance over time.
Each type of ETF has its own set of risks. Learn more about the risks of different types of ETFs.
Summary
Exchange-traded funds are traded on a stock exchange like a stock. Considerations include:
- Similar to mutual funds, ETFs contain a collection of investments such as stocks or bonds.
- Like most investments, there’s no guarantee that you’ll make money with an ETF.
- Investing in ETFs involves paying fees, which may be less than some investments but higher than others.
- You will have to pay taxes on capital gains and distributions.
- Before you invest, read the ETF’s prospectus or its summary disclosure document to understand its investment objective, investment strategies, risks, fees and historical performance.
