What are ETF’s?

ETF’s. It’s one of those common acronyms in the financial industry that gets thrown around a lot, but is rarely explained. I’ve done it myself in my own videos, but today I’m going to rectify that. In today’s episode I’ll be discussing what ETF’s are and what to look out for when considering using an ETF in your portfolio.

Vanguard creates ETF’s. Wealthsimple uses ETF’s. The Canadian Couch Potato recommends buying a few ETF’s. These investment products are becoming more and more prevalent every day. But most young investors I talk to don’t really know what they are, they just feel they should have them.

So, what is an ETF?

It stands for an Exchange Traded Fund. It’s a single product that holds a basket of securities. If you watched my videos outlining Mutual Funds, and in particular, Index Mutual Funds, you’ll have a decent idea of what an ETF is in essence.

First, we need to start with an index. An index provider will create a basket of securities that can be used to measure a specific market (or segment of the market). For example, the S&P/TSX Composite is an index produced by Standard and Poor’s that tracks the Canadian market. The FTSE US Total Market Index is comprised of over 4,500 stock on the US exchanges and is used to represent the US stock market.

Each index provider has their own rules for including companies within the index. While the FTSE US Total Market tries to capture the whole US market, the S&P 500 has decided to only track the largest 500 US stocks. However, these indexes are largely based on pre-set rules, so there isn’t much opportunity for an index provider to include a specific stock because they like it at the present moment, and exclude another stock because they don’t think it will outperform.

ETF providers are then tasked with the job of tracking the index they have chosen. To start, they’ll select their individual index, and build the fund so that the individual holdings in the ETF are in the same proportion as the index. Many of the big ETF’s are based on market capitalization. Market capitalization means the size of the company calculated by multiplying the number of shares outstanding by the company’s share price. For example, the Market Cap of Shopify is just over $16B. This is calculated by taking its TSX listed share price of $174 (at the time of filming this) and multiplying it by the number of shares outstanding, 92.5 million. Royal Bank has a market cap of $144 billion. The ETF will hold the shares of each individual security in the same proportion as their size in the market. This means that Royal Bank’s allocation will be around 9 times higher than Shopify’s within the ETF in this example. If there is an index reconstitution, in other words, if new securities are added to or removed from the index, the ETF provider will have to make those changes to make sure the ETF still tracks the index as closely as possible.

So now that we know how ETF’s work, we can start to see why ETF’s are becoming so popular.

Firstly, investors are getting on board with the idea that passive investing is a good thing. Buying a basket of securities with only one trade keeps transaction costs lower than if you were to go out and purchase a slew of individual stocks or bonds. Not focusing on market timing and trying to select outperforming individual securities frees up time and costs that allow you to focus on things you can really control, like costs, taxes, and creating a plan and sticking to it. The cost for ETF’s is extremely low compared to active mutual funds. A broad market Canadian ETF might cost you 0.06% (or 6 basis points in financial speak) compared to an actively managed Canadian mutual fund than might cost you upwards of 1%. ETF’s are more tax efficient if you have filled up your registered investment accounts like the RRSP and TFSA. This is because there is less selling of individual securities within the fund that results in capital gains taxes being passed on to you.

Like my colleague Ben Felix says, not all indexes are created equal. The same goes for ETF’s. There are now over 500 ETF’s trading on the Canadian stock market alone. There definitely isn’t enough room for 500 plus ETF’s to all track the broad Canadian, US, and International stock and bond markets. While they were initially created to represent a market and track an index, you can now buy leveraged ETF’s (your gains and losses are magnified), inverse ETF’s (in other words, if the Canadian stock market goes up, your Canadian inverse ETF will fall), commodity ETF’s, active ETF’s and the list goes on.

I’ve tried to offer up a brief and general description on ETF’s, but of course there are more intricacies than I’ve presented here. As I’ve alluded to, index mutual funds, and broad market ETF’s are similar. But in a future video, I’ll outline in more detail some of the similarities and differences between the two.