Find out the basics on exchange-traded funds in this article or scroll below for news stories on ETFs
Understanding how exchange-traded funds work is necessary for financial advisors who want to deliver quality service to investors. In this article, Wealth Professional Canada will focus on everything you need to know about ETFs and why your clients should invest in them.
Each ETF issues shares that represent a proportional interest in the underlying assets. When an investor buys a share of an ETF, they own a small piece of every asset in the fund’s portfolio.
Most ETFs are passively managed. This means that they aim to replicate the performance of a specific index rather than outperform it. The fund manager adjusts the holdings only when the underlying index changes. This passive approach often results in lower management fees compared to actively managed mutual funds.
Some ETFs use active management. In these funds, managers make decisions about which securities to buy or sell to outperform a benchmark. Active ETFs usually have higher fees, but they might offer the potential for better returns.
An exchange-traded fund (ETF) is an investment fund that holds a collection of assets. These assets can include:
ETFs trade on stock exchanges like individual stocks. This means investors can buy or sell them throughout the trading day at market prices. They are also designed to track the performance of a specific index or sector.
For instance, some funds follow the S&P/TSX Composite Index, while others might focus on sectors like technology or healthcare. The goal is to provide investors with market exposure or targeted sector exposure in a single, easy-to-trade product.
Watch this video for more on ETFs:
ETFs are an example of pooled investment vehicles, just like mutual funds and segregated funds.
Your clients can choose from a wide range of ETFs, each with unique features and risks. Understanding these types can help you recommend the right products for your clients:
Index ETFs are funds that follow a specific benchmark, such as a stock market index. These are passive investments. The fund’s holdings only change when the index itself changes. Index ETFs can track not only stock indices but also:
The particular index an ETF tracks is vital because it determines how investments are weighted and what kind of returns investors might see. Risks for index ETFs are similar to the risks of the assets in the index.
For example, an ETF tracking an equity index has stock market risk, while a bond index ETF has risks tied to bonds. Returns might not always match the index exactly due to management fees and tracking differences.
Actively managed ETFs do not follow an index. Instead, a professional manager selects investments to meet a specific goal, such as growth or income. The manager can buy and sell assets at any time. This means that these funds often have more trading activity than index ETFs.
This flexibility can help the fund respond to market changes, but it also introduces more risk. It can be difficult to find a good benchmark for performance. There is also a risk that others might copy the manager’s trades if the fund discloses its holdings daily. This can affect prices and performance.
Volatility-linked ETFs are tied to market volatility, often using futures contracts based on the VIX index. These ETFs measure expected swings in the stock market. They are designed for short-term trading and can move up or down quickly when markets are unstable. They are also complex and high risk.
Holding them for more than a day can increase the chance of losses. Volatility-linked ETFs are best suited for advanced investors who understand how these products work.
Specialty ETFs focus on specific assets or strategies. These funds can help investors target certain markets or investment approaches. Common types include:
Commodity ETFs: Invest in physical commodities like gold, oil, or agricultural products. Prices can move quickly, making these funds higher risk.
Inverse ETFs: Aim to profit when an index falls in value. These are designed for short-term use and can be risky if held for too long.
Currency ETFs: Track the value of one or more currencies. These funds can be affected by large swings in exchange rates.
Covered call ETFs: Generate extra income by selling options on the stocks they hold. They can limit gains if stock prices rise sharply.
Managed futures ETFs: Use futures contracts to try to profit in both rising and falling markets. If market trends are unpredictable, losses can occur.
Hedge fund ETFs: Try to mirror the strategies of major hedge funds but might not always reflect the latest holdings.
Foreign ETFs: Invest in assets outside Canada. This can add currency risk and different tax treatment.
Crypto ETFs: Invest in cryptocurrencies. These funds can be very volatile and might use complex strategies.
Single-stock ETFs: Focus on the shares of a single company. They might use leverage or options to try to boost returns, which increases risk.
Each specialty ETF has its own risks and features. Review the fund’s strategy and risk profile before making recommendations.
ETFs are generally considered safe for long-term investors due to their diversification and regulatory oversight. However, they still carry market risk as values can fluctuate. Remember to always assess your clients' risk tolerance and investment timeline first before recommending any ETF.
You can also check out our dedicated page for ETF News to learn more about this investment vehicle.
An ETF is not inherently better than a stock. ETFs offer instant diversification and lower risk by holding many securities. On the other hand, a stock represents ownership in a single company and carries higher risk and potential reward.
The choice will always depend on your client’s investment objectives and overall financial profile. For instance, this investor prefers stocks over ETFs:
Here's a beginner-friendly guide to investing in stocks if that’s what your clients also prefer.
Neither, since both investment vehicles have upsides and downsides. ETFs usually have lower fees, more transparency, and trade throughout the day like stocks. On the contrary, mutual funds might offer more active management and automatic reinvestment.
ETFs offer several advantages that make them attractive to your clients, especially if they want to diversify their asset mix:
One of the main benefits of ETFs is their low cost. Most funds have lower management expense ratios (MER) compared to mutual funds. This is because many ETFs use passive management, and this requires less research and fewer transactions.
ETFs trade on stock exchanges, so investors can buy or sell shares at any time during market hours. This liquidity allows financial advisors to react quickly to market changes or client requests. Unlike mutual funds, which are priced only at the end of the trading day, ETFs provide real-time pricing.
Most ETFs disclose their holdings daily. This transparency helps financial advisors understand exactly what their clients own. It also makes it easier to monitor risk and make sure that portfolios are aligned with client goals.
ETFs allow investors to own a wide range of securities in a single product. This diversification can help reduce risk and smooth out returns over time. Financial advisors can use ETFs to build balanced portfolios that include stocks, bonds, and other asset classes.
Choosing the right ETF involves careful analysis. Try to evaluate these factors before making recommendations:
Investment objective: Start by understanding your clients’ investment goals. Are they looking for growth, income, or capital preservation? The right ETF should align with these objectives.
Underlying index or strategy: Review the index or strategy the fund follows. Some funds track market indexes, while others focus on specific sectors or themes. Make sure that the index is well-constructed and relevant to the client’s needs.
Fees and expenses: Compare the MERs of different funds. Lower fees can help improve long-term returns. However, it is also important to consider other factors like tracking error and liquidity.
Fund size and liquidity: Larger funds with higher trading volumes tend to have better liquidity. This makes it easier to buy or sell shares without affecting the price.
Historical performance: While past performance is not a guarantee of future results, it can provide insight into how the fund has managed different market conditions.
ETFs have improved the way financial advisors build and manage their clients’ portfolios. Their low costs and flexibility make them a valuable addition to one's toolkit. Once you’ve understood the different types of ETFs as well as their benefits and risks, you’ll be able to attend to your clients’ requests more effectively.
Staying updated about new products and regulatory changes will make sure that you’ll continue to deliver value—especially when it comes to investing in ETFs.
Keep scrolling for more news on ETFs or visit our Practice Management page.
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