The EtF advantage - TMXmoney

part I: What is an ETF?

The ETF advantage

Low-cost and versatile, exchange-traded funds can help make investing simpler

i magine an investment that provides many of the advantages of mutual funds--but it's easier to buy and sell, and it has lower fees too. If that sounds good, then it's time to meet one of the hottest investment products out there: the exchange-traded fund, or ETF. Since the first one hit the market 20 years ago, these

nimble investment funds have taken investors by storm. In late 2010, ETF assets reached $1 trillion (U.S.) and there are more than 915 different ETFs to choose from in North America.

Easy trader

If you've ever invested in mutual funds, you're well aware of their advantages.

Rather than dealing with a broker or choosing stocks to invest in on your own, you can buy one mutual fund and let a professional money manager put together a diversified portfolio of stocks or bonds for you.

But while mutual funds can be a great way to start investing, they also have some drawbacks. Buying or selling a mutual fund can take several days. The fees can be high, and while fund managers can add value, they don't always make good stock picks.

ETFs offer a quicker way to buy and sell funds. When you buy an ETF, as with a

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Illustration by Peter Ryan

The etf Advantage

Frequently asked ETF questions

Where can I buy ETFs? You can buy ETFs through a stock exchange, such as the TSX. They can be bought or sold any time the market is open. Many people use a discount brokerage account to buy and sell them.

How do I make money with an ETF? The price of your units goes up if the index your ETF follows rises. So if you bought an ETF that follows the S&P/ TSX Composite, and the Canadian market went up, the price of your ETF would rise too. As with a stock, if you sell your ETF for a higher price than you

paid, you make a profit. If you sell for less than you bought it for, you suffer a loss. Some ETFs hold dividend-paying stocks and pay you regular distributions too.

What's the most common type of ETF? The most common type of ETF is a broad-market ETF. These ETFs follow the big market indexes, such as the S&P/TSX Composite index in Canada or the S&P 500 in the U.S. There are many other types of ETFs though, including sector, industry, countryspecific, commodity, currency, leveraged, short and actively managed ETFs.

Are ETFs good for retirement portfolios? ETFs can be used in your retirement portfolio as part of a buy-and-hold strategy, where the same ETFs may be held for decades. An investor would typically build a diversified portfolio of broad-market ETFs and rebalance them just once a year.

What else can I use ETFs for? ETFs can be used for day trading, currency speculation, commodity trading--almost any kind of investing you can think of. They can be a very

low-risk way to invest, but they can also be riskier than investing in individual stocks. It all depends on how you use them.

2 MoneySense

mutual fund, you get an instant portfolio of dozens, even hundreds, of stocks or bonds. But instead of buying the fund through an adviser and waiting several days for the transaction to take place, you can buy an ETF instantly on the market, just like a stock--they even have ticker symbols. Traditional ETFs also differ from mutual funds in that their managers do not choose the individual stocks or bonds in an attempt to beat the market. Instead, they follow indexes, usually created by third parties, that are designed to give investors the returns of overall markets. This means you can't underperform a market by much, and it helps keep the cost of ETFs low.

Evolution of a market marvel

The world's first successful ETFs were launched by the Toronto Stock Exchange back in 1990. Originally called Toronto Index Participation Shares, they tracked the

TSE 35 index (and later the TSE 100). The success of the participation shares prompted two executives from the American Stock Exchange, Nathan Most and Steven Bloom, to develop a similar investment product for the American market called Standard & Poor's Depositary Receipts, or SPDRs (pronounced "spiders") for short. This ETF,

What is an index?

You know when they refer to the S&P 500 on the news? That's an index. In short, an index is a selection of stocks or bonds that represents a given market. Each index has rules about how many securities are included and how they are weighted. Indexes are mainly used to measure changes in the market they represent.

Illustration by Peter Ryan

statements, annual prospectus reports and

issue proxies and circulars," explains Rich-

How to Open a discount brokerage account

ard Ferri, CEO of Portfolio Solutions, and author of The ETF Book. "On top of that, they need to educate brokers and keep their administrative side up to date and all this takes money. ETFs, on the other hand, are more

A discount brokerage account lets you buy and sell stocks, bonds,

cost-effective. That's translated into lower management fees."

ETFs, mutual funds and other investments by phone or online.

How do you buy ETFs?

Unlike at a full-service brokerage,

That's not to say there are no fees at all with

there is no one to call on for advice,

ETFs, of course. In addition to paying a fee

so the trading commissions are much lower. You can open a discount brokerage account through your bank, or through an independent. The major online brokerages include Scotia iTrade, Questrade, CIBC Investor's Edge, QTrade, TD Waterhouse, RBC Direct Investing, and BMO InvestorLine. Look up the

to cover operating expenses (known as the management expense ratio or MER), whenever you buy or sell an ETF, you have to pay a commission, just like you do when you buy or sell an individual stock.

The most cost-efficient way to buy and sell ETFs is through a discount brokerage. These allow you to set up online accounts

brokerage online and follow the

where you can buy and sell stocks, bonds,

directions to open an account.

mutual funds and ETFs yourself without

having a broker do it for you. There is no

one to provide advice on what to buy or sell,

which still trades with the ticker symbol but the trading fees are much lower. All the

SPY, tracks the S&P 500 index of large U.S. big banks have discount brokerage arms,

companies.

and there are a few independents too (see

Both the Canadian and American ETF "How to open a discount brokerage account,"

products were created to allow investors to above left). The cost of buying and selling

easily get the same return as the indexes ETFs is typically between $5 and $29 a trade,

they tracked. For instance, if an investor depending on your brokerage, the amount

bought the SPY ETF, she would get the same of money you have in your account, and

performance (before fees) as she would get

if she took her money and split it up among

each of the 500 stocks that make up the S&P

500 index (as long as she weighted her investments the same as the index does). The aim was to create a simple investment that could easily give you performance similar to that of an entire market.

THE ETF universe

Most ETFs follow equity indexes, but fixed income, asset allocation and alternative ETFs, some of which include active management, are growing fast

Low, low fees

With a mutual fund, you have to pay your fund manager to choose the individual stocks that go in your fund. But ETFs don't have fund managers because they automatically include the same stocks with the same weighting as their underlying index. Because ETF providers don't have to do stock-picking research and analysis, the fees for ETFs tend to be lower. For instance, the annual fee for the ETF that follows the main index in Canada (the S&P/TSX Composite Index), is about one quarter of one percent. Typical equity mutual fund fees, on the other hand, tend to fall somewhere between 2% and 3%.

"Mutual funds have to issue quarterly

$8,179,099

22%

$25,205,855

68%

$292,306

1%

Asset allocation Alternative

Source: Morningstar

$3,148,345

9%

Equity Fixed income

3

A wealth of diversity to diversify your portfolio:

ETFS...

Listed on

TSX

Over 150 Exchange Traded Funds are listed on Toronto Stock Exchange. Take a closer look at how they can fit into your investment portfolio. etf

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Toronto Stock Exchange is part of TMX Group... equities, derivatives, fixed income, energy, data and over 150 years of know-how under one roof.

The etf Advantage

How do ETFs compare to mutual funds and stocks?

ETFsmutual fundsSTOCKs

Diversification

Usually offer instant diversification

Usually offer instant diversification

You must diversify manually

Fees

The fees on ETFs are low. The average management fee (or MER) is just 0.40%

The fees on mutual funds are higher. The average MER on

a Canadian equity fund is 2.56%

There is no management fee. As with ETFs, however, there is usually a

commission of $5 to $29 per trade

Transparency High (for broad-market index ETFs). The individual holdings are reported daily

Lower. Many mutual funds report holdings quarterly or semi-annually

Highest. You always know what you're holding

Flexibility

High. ETFs can be used for almost any investing strategy, from buy-and-hold to day trading

Lower. Mutual funds are generally only suited for buy-and-hold strategies.

Unit values are set just once a day

High. Stocks can be used for almost any investing strategy, from buy-and-hold to day trading

Tax-efficiency

High. ETFs tend to have lower turnover and their special structure

reduces taxable capital gains

Lower. Frequent trading of securities and investor redemptions can trigger capital gains

Varies. Depends on your investing strategy and what type of account

your stocks are held in

The top 3 ETF RISKS

Exchange-traded funds (ETFs) carry risks, just like any investment. Before buying ETFs, keep in mind:

?There's no guarantee that you'll make money with an ETF, as no one can predict how a market or sector will perform in the future.

?ETFs that track narrow sectors

(such as oil or gold), or use complex strategies (such as leveraging) are more volatile than traditional index ETFs. This volatility increases your risk of suffering losses.

?ETF costs can be high when using dollar-cost averaging strategies (automatically investing small amounts on a scheduled basis) to build your portfolio. Your trading commissions can eat away at your total return.

how frequently you trade. After you buy, your ETFs rise and fall in

value along with the index they follow. You make money if you sell your ETF for more than you bought it for, and you lose money if you have to sell it for less. Some ETFs pay you regular dividend income as well.

Tax-efficient, too

The final reason many investors like ETFs is because they are tax-efficient. Whenever a fund sells stocks or bonds at a profit, it generates capital gains, and these gains usually mean a higher tax bill for investors. ETFs tend to have a lower turnover than mutual funds, because they hold on to their stocks for as long as the companies remain in the index. They also use an innovative structure that allows them to avoid having to sell the underlying securities whenever investors redeem units in the ETF. "This makes the ETF basket much more tax-efficient than a mutual fund," says Ferri. In fact, many ETFs have managed to entirely avoid passing on taxable

capital gains to their investors. Today there are hundreds of ETFs follow-

ing every imaginable sector in the stock and bond markets. There are ETFs following commodities, precious metals and currencies. ETFs now follow different types of index structures, some have leverage built in, and some don't even directly buy the stocks they follow. In May, look for the next booklet in our four-part series on ETFs, where we'll take a closer look at how to trade ETFs effectively. M

The benefits of ETFs

?Quick and cost-effective diversification

?Easily bought and sold, like stocks Usually simple and transparent

??Tax-efficient

*Printed on Rolland Opaque50 paper stock

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moneysense.ca/etfadvantage

Current contest period ends March 31, 2011. Contest closes Dec. 8, 2011. Must be a Canadian resident over the age of majority in their province or territory of residence to enter. One entry per person. For full rules visit MoneySense.ca/etfadvantage. Odds of winning depend upon the number of eligible entries received. Mathematical skill testing question to be correctly answered to win. No purchase necessary. There are four contest periods: Jan. 17-Mar. 31, Apr. 1-June 29, June 30-Sept. 30, and Oct. 1-Dec. 8, 2011, each with a Grand Prize available to be won, each consisting of a cheque in the amount of $1,000 to be invested with an Exchange Traded Fund. Not a recommendation or endorsement of any specific securities, nor the advisability of investing in securities generally for any particular individual. Please seek the advice of professionals, as appropriate, regarding the evaluation of any specific security or type of security.

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