How do ETFs work?
Your guide to how ETFs work and how to decide whether or not this type of investment is right for you.
ETFs are one of the easiest ways to invest in a diversified portfolio without having to pick individual stocks or bonds. They’re popular with beginners for their simplicity and with experienced investors for their versatility. But exactly how do ETFs work and how can you use them to make money? Keep reading to find out.
What is an ETF?
An exchange-traded fund, or ETF, is an investment fund that pools money from many investors to buy a diversified collection of assets, such as stocks, bonds, currencies or commodities.
When you purchase a share of an ETF, you don’t directly own the underlying assets or companies. Instead, you own a share of the fund, which gives you instant exposure to multiple investments through a single trade.
Unlike mutual funds, ETFs trade on stock exchanges, allowing investors to buy and sell shares at fluctuating market prices whenever the exchange is open. ETFs also charge a management expense ratio (MER), which is deducted automatically from the fund.
How do ETFs work?
ETFs are created and managed by fund providers that assemble a basket of assets designed to track a specific index, sector or investment theme like sustainability. Large financial institutions, known as authorized participants, create or redeem ETF shares as needed to help keep the ETF’s market price close to its net asset value (NAV).
Most ETFs are passively managed and aim to replicate the performance of their underlying benchmark by holding the same securities in similar proportions, so if Amazon (AMZN) represents 3% of the market index, it will also make up 3% of the ETF’s holdings. However, some ETFs are actively managed, with portfolio managers selecting investments in an attempt to outperform the market.
Key terms for ETFs
| Term | Definition |
|---|---|
| Number of holdings | This refers to how many individual securities (such as stocks or bonds) an ETF owns. An ETF with more holdings is typically more diversified. |
| Holding allocations | Holding allocations show how much of the ETF is invested in each security, usually expressed as a percentage of the total portfolio. |
| Management expense ratio (MER) | The MER is the annual fee charged by the ETF provider to manage the fund, expressed as a percentage of assets. It covers operating and management costs and is deducted automatically. |
| Trading volume | The number of shares or units of a security that are bought and sold over a specific period, often used to gauge market activity and liquidity. |
| Distribution frequency | This indicates how often the ETF pays out income to investors, such as monthly, quarterly or annually. Distributions can include dividends, interest or capital gains, depending on the ETF’s holdings. |
| Distribution yield | The distribution yield represents the income an ETF pays out relative to its price, usually shown as a percentage. It’s often based on recent distributions and can fluctuate over time, especially for income-focused ETFs. |
| Sectors | Sectors describe the industries or parts of the economy the ETF is exposed to, such as technology, healthcare or energy. |
| Underlying index | Many ETFs are designed to track a specific index, such as the S&P 500 or Nasdaq-100. The underlying index determines which securities the ETF holds and how they’re weighted. |
| Net asset value (NAV) | NAV is the per-share value of the ETF’s underlying assets. ETF prices usually trade close to their NAV, but can be slightly higher or lower during market hours. |
| Liquidity | Liquidity refers to how easily an ETF can be bought or sold without significantly affecting its price. It’s often influenced by trading volume and the liquidity of the ETF’s underlying holdings. |
| Tracking error | A tracking error is the difference between an ETF’s performance and the performance of the index it’s designed to track. It occurs due to factors like management fees, trading costs, cash holdings and currency effects. |
Features of ETFs
ETF features include:
- Passive or active. Many ETFs are passively managed and aim to mirror the returns of a benchmark index. But some funds are actively managed to try and outperform an index.
- Low cost. You’ll pay much less in brokerage fees if you invest in a single ETF rather than buying stocks in individual companies. In fact, many online brokers don’t charge any commissions on ETF trades, while ETFs tend to have lower expense ratios than mutual funds.
- Tax efficient. ETFs tend to incur less capital gains tax than mutual funds, which trade assets much more frequently. In the words of the U.S Securities and Exchange Commission (SEC), “Taxes on ETF investments have been historically lower than those for mutual fund investments.”
- Open-ended. Most ETFs are open-ended, which means there’s no limit on the number of shares the fund can issue.
- Intraday trading. ETFs trade on stock exchanges throughout the day, allowing investors to buy and sell shares at real-time market prices.
- Transparency. Most ETFs disclose their holdings daily, so investors can easily see exactly what assets the fund owns.
Are ETFs good for beginners?
Generally speaking, yes. ETFs offer a simple and convenient way for novice investors to build a diversified portfolio. They’re easy to buy through online brokers, can be started with a small investment and typically have lower fees than buying many individual stocks.
Of course, you’ll also need to consider management fees. Plus, ETFs often come with lower risk than investing in individual stocks, but don’t offer the same potential for high rewards. As for leveraged and inverse ETFs, those are better suited to more experienced investors.
How do you make money from ETFs?
There are two main ways to make money from ETFs:
- Dividends and interest. Many ETFs pay out income generated by their holdings, such as dividends from stocks or interest from bonds. These payments are usually distributed monthly, quarterly or annually and can be reinvested or taken as cash.
- Capital gains. If the price of the ETF shares rises after you buy them, you can sell your shares for a profit called capital gains.
What are the different types of ETFs?
There are many different types of ETFs you can invest in, including:
- Passive ETFs. Passive ETFs aim to track the performance of a specific index or benchmark, such as the S&P 500 or TSX 60.
- Active ETFs. Active ETFs are managed by portfolio managers who make investment decisions to try to outperform a benchmark or achieve a specific investment objective. They may trade holdings more frequently than passive ETFs.
- Sector and industry ETFs. These ETFs focus on a specific sector or industry, like technology, healthcare, energy or finance.
- Bond ETFs. Also known as fixed-income ETFs, bond ETFs invest in bonds and other fixed-income securities. Bond ETFs can be traded on stock exchanges (just like stock ETFs) and pay interest in the form of a monthly dividend. Any capital gains are distributed to investors through annual dividends.
- Commodity ETFs. As the name suggests, commodity ETFs are designed to track the performance of commodities such as gold and other precious metals, oil and gas and agricultural goods.
- Currency ETFs. Currency ETFs provide exposure to foreign currency by tracking the performance of a single currency or a basket of currencies relative to the Canadian or US dollar.
- Cryptocurrency ETFs. Cryptocurrency ETFs are funds that track the price of a digital currency, like Bitcoin or Ethereum, allowing investors to gain exposure to crypto without directly owning it.
- Inverse ETFs. Rather than tracking the performance of a benchmark index, inverse ETFs are designed to produce the opposite returns. In other words, if the index goes down, the value of the ETF goes up. They’re useful for hedging against other investments but are only suitable for short-term trading, as the expense ratios can be high.
- Leveraged ETFs. A leveraged ETF doesn’t only track an index — it aims to double or even triple its returns. These ETFs use derivatives to magnify your exposure to the investment without requiring you to invest any additional capital. However, while any gains are amplified, so too are any losses. Most leveraged ETFs reset to the benchmark index each day and are therefore only suitable for short-term trading.
Taxes on ETFs
When you invest in ETFs in Canada, the tax you owe depends on the income you earn.
- Canadian dividends: If the ETF pays dividends from Canadian companies, they may be eligible for the dividend tax credit, which reduces the amount of tax you owe by giving you credit for the corporate tax already paid on that income.
- Foreign dividends: Dividends from foreign companies are fully taxable at your marginal tax rate and may be subject to withholding tax in the foreign country. You may be able to claim a foreign tax credit to avoid double taxation, though, depending on the country where the ETF is based.
- Interest: ETFs that earn interest, such as bond ETFs, are taxed as ordinary income at your marginal tax rate.
- Capital gains: When you sell an ETF for more than you paid, you earn a capital gain. Only 50% of the gain is taxable at your marginal rate.
To avoid or defer paying taxes on the income you earn from Canadian ETFs, you can hold them in a registered account. In these accounts, dividends, interest and capital gains grow tax-free or tax deferred, with taxes either postponed until withdrawal with a registered retirement savings plan (RRSP) or eliminated entirely with a tax-free savings account (TFSA). This doesn’t apply to foreign ETFs.
Pros of ETFs
- Diversification
- Low management fees
- Easily buy and sell like stocks
- Holdings are transparent and updated frequently
- Access to niche sectors or markets
Cons of ETFs
- Subject to market fluctuations
- Frequent trades can add costs
- May not perfectly match index performance
- Leveraged/inverse ETFs can be risky long-term
How are ETFs different from mutual funds?
For a novice investor, it can be difficult to tell the difference between an ETF and a mutual fund. Both types of funds invest in a basket of assets, providing easy diversification, but there are a few key differences:
- Passive vs active. ETFs were traditionally passively managed to track an index, while mutual funds were known for being actively managed. However, actively managed ETFs and passively managed mutual funds are now widely available.
- Expense ratios. Mutual funds generally have higher management fees than ETFs due to being actively, rather than passively, managed.
- How funds are traded. Buy and sell ETFs on exchanges just like stocks, but mutual funds can only be bought or sold at the end-of-day net asset value. ETFs can also be purchased through a wider range of brokers than mutual funds.
- Initial investment. If you choose a broker that offers fractional shares, you can invest in an ETF for as little as $1. However, mutual funds come with set minimums that could be $500 to $5,000.
- Taxation. ETFs are generally more tax-efficient than mutual funds, with the latter usually likely to have higher capital gains taxes.
Dive deeper: ETFs vs Mutual funds
How are ETFs different from stocks?
ETFs and stocks are both traded on exchanges, but they represent different types of investments and come with distinct characteristics:
- Basket of assets vs single company. A stock represents ownership in a single company, giving you a claim on its profits and voting rights. An ETF, on the other hand, holds a collection of assets, so you don’t directly own any of the individual companies, just a share of the fund itself.
- Volatility. Individual stocks can be highly volatile because their price depends on a single company’s performance. ETFs tend to be less volatile since gains and losses are spread across multiple holdings.
- Dividends. Stocks may pay dividends from the company’s profits, while ETFs can pay dividends from all the holdings within the fund, often on a quarterly basis.
- Investment strategy. Stocks require research on individual companies, while ETFs allow investors to gain broad market or sector exposure without picking individual stocks.
- Risk management. ETFs can help reduce risk through diversification, whereas owning only a few stocks exposes you to higher company-specific risk.
What to consider when choosing an ETF
Before investing in any ETF, take some time to read its prospectus. This document lays out all the essential information you need to know about a fund. Make sure you check the fund’s:
- Investment objective. What index does the fund aim to track or what performance does it aim to deliver, and in what timeframe? Does this align with your investment goals and risk/reward appetite?
- Expense ratio. Compare the expense ratio across a range of funds to work out how much you’ll pay in management fees.
- Prior performance. Check out how the ETF has performed over the past 1, 3, 5 and 10 years. How does this compare to other similar funds? Of course, remember that past performance is no guarantee of future success.
- Trading volume and liquidity. Take a look at an ETF’s trading volume to get an idea of its liquidity. Higher liquidity means tighter bid-ask spreads and will make it easier to sell shares in the ETF whenever you need.
- Tracking difference. Check whether the fund has accurately tracked its underlying benchmark index. For example, if the index went up 10%, did the ETF also increase by 10% — or was there a tracking difference?
How to invest in ETFs
Follow these steps to invest in ETFs in Canada.
1. Choose the right account
Decide whether to invest through a registered account, like a TFSA or RRSP or a non-registered account. Registered accounts offer tax advantages, such as tax-free growth or tax deferral, which can help your investments grow faster over time. Non-registered accounts provide more flexibility but may be subject to taxes on dividends, interest and capital gains.
2. Open an account with a brokerage
You’ll need a brokerage account to buy and sell ETFs. Online brokers and investment platforms in Canada allow you to trade ETFs listed on Canadian and U.S. stock exchanges. Compare different brokerages for fees, account types and the range of ETFs offered. The following brokerages support ETF and stock trading:
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3. Fund your account
Transfer money from your bank account to your brokerage account to start investing. Some platforms allow you to set up automatic deposits, which can make investing a consistent habit. Make sure you keep enough funds in your account to cover the ETF purchase and any trading fees.
4. Research ETFs
Take time to review different ETFs and see which one aligns with your goals and risk tolerance. Look at the fund’s underlying assets, management fees and how diversified it is across sectors or regions. Also consider factors like liquidity, distribution frequency and past performance to help make an informed choice.
5. Place your order
Decide whether to use a market order, which buys the ETF at the current price, or a limit order, which buys only at a price you set. Enter the number of shares you want to purchase and review the total cost, including any fees. Once you place the order, your brokerage will execute the trade, and you’ll officially own shares of the ETF.
6. Monitor and manage your investments
Keep an eye on your ETFs and your overall portfolio to make sure they still align with your financial goals. Reinvest dividends whenever possible to take advantage of compounding returns.
Popular ETFs in Canada
Here are some of the best Canadian ETFs you can consider investing in:
- iShares S&P/TSX 60 Index ETF (XIU): Tracks 60 large Canadian companies
- Vanguard FTSE Canada All Cap Index ETF (VCN): Includes large, mid and small-cap Canadian stocks.
- iShares Canadian Select Dividend Index ETF (XDV): Focuses on high-dividend Canadian stocks.
- iShares S&P/TSX Capped Financials Index ETF (XFN): Exposure to Canadian banks and financial companies.
- BMO Aggregate Bond Index ETF (ZAG): Diversified Canadian bonds.
Bottom line
ETFs are worth considering for both novice and more experienced investors, offering an easy and inexpensive way to gain exposure to a diverse portfolio of assets. However, it’s important to understand how ETFs work and compare a range of funds before deciding where to invest your money.
Dive deeper: How to buy ETFs
Frequently asked questions about ETFs
Sources
Important information: Powered by Finder.com. This information is general in nature and is no substitute for professional advice. It does not take into account your personal situation. This information should not be interpreted as an endorsement of futures, stocks, ETFs, CFDs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for most investors. You do not own or have any interest in the underlying asset. Capital is at risk, including the risk of losing more than the amount originally put in, market volatility and liquidity risks. Past performance is no guarantee of future results. Tax on profits may apply. Consider the Product Disclosure Statement and Target Market Determination for the product on the provider's website. Consider your own circumstances, including whether you can afford to take the high risk of losing your money and possess the relevant experience and knowledge. We recommend that you obtain independent advice from a suitably licensed financial advisor before making any trades.
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