Though most investors believe that equities will, over time, outperform fixed-income investments, they still fear the stock market. They worry that they, or their mutual fund, will pick the wrong stocks. Exchange-traded funds, or ETFs, can help you overcome this fear, and let you build a conservative investment portfolio.
Exchange-traded funds, or ETFs, are trusts comprising the stocks of some stock-market index, in the same proportion as they appear there. For example, iShares S&P/TSX 60 Index ETF invests in stocks in the same proportions as they appear in the S&P/TSX 60 Index, which is comprised of 60 major large-cap Canadian stocks. But ETFs differ from index mutual funds in a couple of ways. First, as the name implies, ETFs trade on a stock exchange in the same manner as shares of listed companies.
That means daily buying and selling of these shares won’t affect the portfolio of the underlying funds. When you invest in a mutual fund, the manager must put your money to work. And when you redeem, the manager must raise enough cash to redeem your units. But in the case of ETFs, you buy from and sell to other investors.
The only money moving into and out of the actual underlying ETF portfolio involves large blocks of stocks called creation and redemption units. This feature serves to keep the market valuations of ETF shares close to their net asset values. That makes them different from closed-end investment trusts, many of which trade at substantial discounts to their net asset values.
ETFs have a cost advantage
A key advantage of exchange-traded funds is that the mechanical and computerized nature of their portfolios gives them a significant cost advantage over fully-managed mutual funds and even over index mutual funds. The latter must, for example, deal constantly with relatively small amounts of money. What’s more, ETFs have little customer-service requirements, and tracking the issue and redemption of shares is a minor task occurring as it does in creation and redemption units only.
The result is low management expense ratios, or MERs. In the case of a broadly-based market index like the S&P/TSX Composite Index, for instance, the MER of the iShares ETF that tracks this index is just 0.05 per cent. That compares quite favorably to an MER of 0.88 per cent for TD Canadian Index, a mutual fund that tracks the same index. What’s more, the median MER of managed Canadian equity funds is 2.46 per cent.
This capacity to keep costs low, along with the relatively poor performance of many managed funds, has led some observers to argue that ETFs are superior to managed funds. We don’t think the situation is that clear cut, but it’s true that just 43 of 177 Canadian equity funds outperformed the iShares S&P/TSX Capped Composite Index ETF over the past 10 years.
ETFs are more tax efficient
Another benefit of ETFs is their tax efficiency. Their creation and redemption structure eliminates the effect of shareholder trading on capital gains distributions. What’s more, they only buy and sell when stocks are added to or removed from the index. Managed funds, by contrast, tend to buy and sell more — some of them, a lot more. The low turnover of ETFs, then, not only keeps expenses down, but it minimizes the capital gains distributions you’ll receive from year to year.
ETFs also provide greater transparency than managed funds. That’s because they disclose their exact holdings on a daily basis, while managed funds do so less frequently.
ETFs also give you instant diversification. However, since ETFs are passive investments, their portfolios can become heavily tilted to certain sectors. That’s true of those that track the Canadian stock market, which is heavily weighted with financial and resource stocks.
Money Reporter, MPL Communications Inc.
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