ETFs 101 – Part I

Since one of the focus areas of this site is going to be ETFs, I thought it would be a good idea to cover some basics of ETFs.

What is an ETF?

ETF stands for Exchange Traded Fund. An ETF is typically a collection of securities/assets (ie, stocks, bonds, commodities, currencies, or a combination) that are usually designed to passively track some market index.  An ETF, as the name implies, trades on the stock exchange similar to other stocks.

Types of ETFs

There are different types of ETFs available including

  • ETFs to track stocks, bonds, commodities, and currencies
  • ETFs to track countries and sectors/industries
  • Leveraged ETFs – which give you exposure of 2-3 times the market moves on a daily basis.
    • Eg: If the stock market moves 1% up or down, the leveraged ETF will change 2-3% in price
  • Inverse ETFs – go up in value if the asset it is designed to track goes down in value and vice versa
  • ETFs to track different strategies such as covered call writing

Other ETFs are coming on the market with more sophisticated strategies and may not be a purely passive index strategy.  For instance, Horizons ETFs has a line–up of actively managed ETFs available.  Although some of these go against the principle of passively tracking indices, they may be useful investment tools to achieve investment goals or needs.

ETFs versus Mutual Funds

—ETFs can be used instead of traditional mutual funds to achieve investment objectives.  —Studies show that it is difficult for actively managed mutual funds to consistently outperform the index it is tracking over the longer term.  According to the —Standard & Poor’s SPIVA Canada Year-End 2011 Report, the percent of active fund managers under-performing the index over 5 year period (ending Year-End 2011) are as follows:
  • —Canadian Equity (S&P Composite Total Return Index) – 97.26%
  • —US Equity (S&P 500 Index in Cdn dollars) – 89.01%
  • —International Equity (S&P EPAC LargeMidCap Total Return, Cdn dollars) – 93.88%
This means if you are investing in mututal funds, over the long run, your mutual fund will likely under-perform the index it is tracking!!  I would imagine on an after-tax basis, the under-performance would be even worse.

ETF Providers in Canada

For a list of Canadian ETF providers, visit the Links and Resources page.

In Part II we’ll dive into the advantages and disadvantages of ETFs versus mutual funds.


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