While exchange traded funds (ETFs) have enjoyed increasing popularity over the last decade, there are still a number of widely held misconceptions about this type of investment.
1. “ETFs only offer broad-market exposure”
Many ETFs offer broad-market exposure by tracking a broad market index, such as the S&P 500 Index. These broad-market ETFs were one of the first types of ETF created and still represent the majority of ETF assets. However, over the last decade, the ETF landscape has greatly evolved to include a much broader choice of ETFs, including:
- ETFs that focus on specific asset classes (i.e., small-capitalization equities, high-yield bonds), sectors (i.e., real estate, energy) or geographies (i.e., emerging markets, Europe).
- ETFs using specific factors or rules to select and weight securities, including value, growth, dividend income and volatility.
- Actively managed ETFs where an investment team makes ongoing decisions regarding portfolio construction. These can be focused on a variety of markets and sectors and markets and deliver investment returns that do not track an index.
2. “ETFs trade exactly like stocks”
ETFs and stocks are alike in that they both trade on an exchange and the same order types apply, such as market and limit orders, but they also differ in some key respects.
Stock prices are driven by supply and demand between investors in the marketplace. If a particular stock is popular in the market (i.e., there are more buyers than sellers), its price rises to reflect this demand.
An ETF’s trading price is based on the value of the securities held in its portfolio. Market makers calculate an ETF’s portfolio value throughout the day to determine bid and ask prices for the ETF.
Stocks have a set number of shares available in the marketplace. Stock liquidity largely reflects the average volume of shares trading on the market and how easily those shares can be bought and sold without affecting their price.
ETF liquidity has several components – the volume of units traded between investors on an exchange, the liquidity provided by market makers through the units they hold in their inventory and the creation/redemption process that is unique to ETFs.
ETFs are open-ended, which means that units can be created or redeemed based on investor demand. This process is managed by market makers. The liquidity posted by market makers is affected by how easily the market maker can buy and sell the securities held within the ETF’s portfolio. Thus the liquidity of an ETF is strongly related to the liquidity of the individual securities in the ETF’s portfolio. Although an ETF might have only modest trading volume, the creation/redemption process means that it is still possible for investors to buy or sell a large number of units without moving the price.
3. “ETFs are all low cost”
While ETFs are well-known for giving investors access to index-tracking strategies at low cost, there is a wide variety of ETFs available in Canada. Approximately 60% of Canadian-listed ETFs do not track broad-based indexes, and instead follow factor-oriented, active, and other strategies. With over 700 ETFs (and counting) now available in Canada, there are many different cost structures that correspond with different investment strategies. ETF management fees range from just a few basis points to almost one percentage point per year (and higher). Investors have to determine which ETFs represent the best value – the right fit for the right cost – to help them achieve their investment goals.
While cost is a factor in deciding which ETFs are the right fit for your portfolio, it should not be the only factor. In addition to costs, investors should consider other factors, such as how the ETF meets their investment objectives (i.e., income, diversification, long-term or short-term strategy) and risk tolerance.