Exchange-Traded Funds (ETFs): The Good, the Bad and the Ugly

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Exchange-traded funds or ETFs represent a category of investments (such as bonds and stocks), that you can hold in your portfolio. ETFs have become extremely popular over the last decade and are often defined by opposition to mutual funds. This article will provide more insight for beginning investors, in an attempt to help you determine if ETFs are right for you or not.

What are Exchange-Traded funds?

A good definition of ETFs can be found on Investopedia: “An ETF, or exchange-traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange.” Like a mutual fund, an ETF is a portfolio that may contain one or several types of assets (bonds, stocks, commodities, etc.). That fund is then divided in shares that people like you and I can buy at a relatively low price. However contrary to mutual funds, ETFs can be traded directly by the share owners on financial markets through a brokerage account (exactly as you would do with stocks and bonds). There are other key differences between ETFs and mutual funds that will be discussed below.

Key things to know about ETFs

  • ETFs are not risk-free instruments. Like most assets traded on financial markets, it is possible to lose money depending on the performance of the underlying assets in the ETF, economic factors and market fluctuations. Also, like any instrument, past performance is not necessarily indicative of the future.
  • In your brokerage account, you can buy and sell ETFs in a similar way you would with stocks and bonds
  • You will usually pay a transaction fee or commission when you trade ETFs.
  • Like in a mutual fund, investors make money in the form of interest, capital gains or dividends based on the number of fund shares they have bought. So unless your ETFs are held in a tax-exempt vehicle (ex: 401(k), RRSP or TFSA), you will usually be subject to a dividend income tax and capital gains tax when you receive distributions from the underlying assets.

Advantages of ETFs

  • Risk Diversification: Because ETFs track a basket of instruments, your risk is spread over several assets. For example, if one stock in the ETF is doing poorly, the others may perform better and thus balance the overall risk. This advantage can also be found in mutual funds.
  • Liquidity: The main advantage of ETFs over mutual funds is their liquidity and marketability. In other words, you can trade (buy, sell, short, etc.) your ETFs on a brokerage exchange, exactly like you would do with your stocks. This provides a tremendous amount of flexibility, because it takes a fraction of the time to trade ETFs than to adjust your mutual fund composition (which generally requires the manual intervention of  your financial advisor).
  • Lower Cost: ETFs are generally cheaper to trade than mutual funds, which come with high management fees that cut into your profits. This is a particularly attractive feature of ETFs, as you only get charged by transaction. However if you trade very frequently, those fees can add up quickly.
  • Transparency: Mutual funds are only required to disclose their performance on a quarterly basis, and seldom disclose the full list of holdings that are in the fund. ETFs on the other hand, allow you to track your positions on a daily basis.
  • Variety: For an individual investor who may not have huge sums of money to invest, ETFs provide access to a wide range of instruments that would be otherwise restricted in mutual funds. Real Estate Investment Trust (REITs) are a good example. With relatively low funds, you can also decide to invest in ETFs specialized in small caps, large caps, emerging markets, commodities, etc.
  • Tax efficiency: When you want to withdraw money from a mutual fund, the financial institution has to sell your holdings, which results in a capital gains tax that is transferred to you. However ETFs are simply traded between investors and no underlying assets must be sold just because shares of the ETF are sold. This can help you save on taxes on most cases.

The Growing Danger of ETFs

Due to their tremendous popularity, ETFs have drastically increased the volume and frequency of transactions done by non-expert investors like you and I. There are now more than 2,000 ETFs listed on U.S exchanges alone (Financial Times, 2017). ETFs and index-funds are part of what we call passive investing, by opposition to say, mutual funds and hedge funds, which are actively managed by portfolio managers. However actively managed funds are more expensive (fund managers have to be compensated for their stock-picking skills, their diversification and profit-maximizing strategies). Mutual fund management fees can be as high as 1.5% (sometimes bringing your total net return below inflation in moments of low performance). It is therefore no surprise that individual investors have transferred trillions of dollars from mutual funds to passive instruments like ETFs, which may provide similar diversification advantages. However this requires investors to rely on their own instincts and knowledge to make decisions about buying or selling. Before, it was mostly amateur day traders who would engage in such operations, but today ETFs have democratized financial markets, with the risk of having millions of individual investors trading without fully understanding the nature of the ETFs, which can often be very complex (ex: derivative-based ETFs). This has increased the average volatility of financial markets, with bigger upward and downward swings in asset prices that a decade ago. It is hard to evaluate the exact contribution of ETFs to market volatility, but several experts have raised concerns about a potential bubble that could burst in the event of another financial crisis.

Conclusion

ETFs can be a cheaper alternative to mutual funds for the beginning or amateur investor. You don’t have to micromanage each stock, as you already benefit from diversification. However it is a good idea to talk to a broker about what your investment goal, to see if ETFs are the right choice for you. Like any investment, there’s going to be risks as well as rewards, and you should do your research before investing substantial amounts in ETFs.

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