Exchange-traded funds (ETFs) are an alternative to investing in mutual funds or actively managed funds with an MER in the 2% range. For people who are new to investing, ETFs can be a bit of a mysterious concept that they’re unclear about.
For this article, we’ll look at what ETFs are and whether they are a good investment for you.
Table of Contents
What Are ETFs?
Exchange-traded funds are a type of tradeable security on the market.
They are available for investing in stocks, bonds, and other types of securities in a collective holding. For instance, the purchase of an ETF may expose the investor to over 500 stocks in an index, such as the S&P 500 index, with a single holding. This is far more efficient than attempting to purchase all 500 stocks individually.
There are now ETFs for the Canadian stock and bond markets. Also, other ones offer U.S. market exposure, international, and global investment too. Some even offer the potential to invest in companies or bonds from the Far East, such as Malaysia, Thailand, and Singapore.
Do They Trade Differently to Mutual Funds?
ETFs are traded in the market similar to a stock. They have live pricing while the market is open and trading. Whilst they sometimes trade thinly and require extra time to complete a requested trade, the more popular ETFs have over a billion dollars in assets under management with no liquidity issues. A lot of people who have invested in mutual funds are now asking how do etfs work? If you’re one of them, you can read the article by clicking on the link.
Slow Sale of Mutual Fund Positions
If investors want to sell a mutual fund, the request is submitted, and the position is sold. This can require a few days or even longer to complete. When the market is in a defined downturn, investors are unable to exit efficiently from their positions because of how slow transactions are completed by mutual funds.
Stop-Loss Orders May Protect ETF Investors
ETFs trade frequently in many cases. As such, investors can create stop-loss orders in an attempt to trigger an automatic sale of their ETF positions when their price declines below a set price. Depending on the market action and ETF liquidity at the time, a stop-loss order may not get filled as intended, so it doesn’t always save you from a falling knife. However, mutual funds don’t have this option at all.
Is Rapid Trading with ETFs Advantageous to an Investor?
Some estimates suggest that the average holding period for many ETFs is just days or weeks, rather than longer-term. Research indicates that some S&P 500 ETFs are traded as much as 25-30% every day whereas Vanguard ETFs trade only a few percentage points daily. So, the ETF turnover rate varies dramatically depending on the ETF.
Is the Option to Rapidly Trade a Positive or a Negative?
It’s potentially both.
On the one hand, there’s no arguing with the fact that in a market crash, having at least the option to attempt to liquidate an ETF position could be highly beneficial. If willing to accept the potential early realized capital gains on the profit part of the sale, an investor could still come out whole.
On the flip side of that coin, investment history has long demonstrated that investors tend to be their own worst enemies. This has historically been due to a mix of excessive trading adding to expenses, losing time in the market, and poor market timing.
Investors typically buy high and sell low, in a panic when prices have steeply declined. Only when they’ve calmed down because prices have substantially rebounded and they’ve regained their confidence again, do they buy back in. Unfortunately, the resulting sale at the low point and overpaying later is something they pay dearly for. This is why many investors perform poorly against broad market indices.
Are ETFs Fundamentally Good or Bad?
They’re neither.
They are simply another investment tool that willing investors have in their arsenal.
It’s a matter of using them well, avoiding any potential negatives (like trading them too often), and investing for the long term.
ETFs can be good for you when used appropriately by accentuating their positives.
Do Costs Matter? Do ETFs Have the Edge?
To appreciate expenses (the MER of an ETF or mutual fund), it’s necessary to see them in the context of the bigger picture with potential investment returns.
Stock Market
While the S&P/TSX Composite Index provided investors a 9.3 percent annualized return from 1960 to 2020, the future isn’t expected to be as generous. Estimates range between 6 to 7 percent in the future due to reduced average cash dividend yields and potentially slower growth than in the past too.
Fortunately, real returns (after inflation) may still be reasonable if inflation remains at historically low levels.
The real returns from stocks are unlikely to provide much more than 4% annually. Some years will be far better, and others perform poorly, but overall, this is what is believed.
Bond Market
With Canadian government bonds, the picture is worse.
Interest rates for bonds sit around 1.5% in mid-2021 with real returns expected to be flat. Looking at this chart, it’s possible to observe that government bonds vacillate between providing investors with a positive 0.50% return and a negative 0.50% return depending on the year.
Interest rates currently sit at historic lowers, so can only go either up, or remain unchanged. Also, current inflationary indicators brought on by recent stimulus packages are putting pressure on retail prices. This may require an increase in the Canadian base rate to stem the tide and bring inflation down again. Unfortunately for bond investors, rising interest rates have an inverse effect on bond values. So, if interest rates do rise in the future, bond investors may lose more than their 0.50% potential upside.
MER and Why It Matters
While stocks and even bonds occasionally surprise with outsized return sequences, the long-term real returns (above inflation) don’t change all that much. Companies do not magically begin growing at double their usual rate or pay twice the dividend either. Things are never “different this time.”
Therefore, with only 4% or even a generous 5% in real returns to grow investments (and later to live off them in retirement), there’s much to play with. The average MER in Canada is still an excessively high 2%. That’s 40-50% of the potential real growth in the investment portfolio being gobbled up in mutual fund fees!
Due to this reality, many investors are using index funds to cut costs while still getting the market return. And those wanting more control over their indexed portfolio, including exiting bad or declining markets faster, look to ETFs.
Is It Worth Trying to Beat the Market?
Very few Canadian or U.S. active funds beat the market. It’s simply too efficient with the information being known about companies way before the average investor can react. By which time, that new knowledge is already priced into the stock and there’s no way to benefit from it.
A far better strategy is to look for the best Canadian ETFs that follow an indexing strategy. This allows you to benefit from efficiencies, lower costs, and simplicity. Wealthsimple has provided the above-linked list of the better ETFs to consider. They offer an investor-oriented platform with total control over your investment strategy coupled with commission-free trading too.
Should You Hedge the US Dollar for USD Assets?
Investors who wish to invest in the U.S. stock market to diversify away from the resource-heavy Canadian market need to consider currency exposure.
The currency conversion rate between the loonie and the U.S. dollar bounces around unpredictably. So much so that Canadian investors can lose money even when the S&P 500 index has a positive return. Fortunately, it’s possible to enjoy hedging with some ETFs where currency rates don’t materially affect returns.
For instance, the Vanguard S&P 500 Index ETF (CAD-hedged) provides returns that are hedged in Canadian dollars. Subsequently, they aren’t affected by a weakened loonie against the dollar, which protects Canadians from something they cannot personally control.
Hedging at least part of a Canadian portfolio is certainly worth considering, but it’s a personal decision about whether it’s necessary and to what degree?
What Role Do Bonds Play in a Balanced Portfolio?
Bonds are designed to provide ballast to a portfolio.
A balanced portfolio should include some cash, bonds, and stocks. The cash may be in a checking account or a money market account. Bond and stock exposure can be sought through ETFs or another investment type.
Bonds rarely provide a sustained profit. Usually only in a steadily declining interest rate environment is that true. What they do provide is an ownership position in government (or corporate) debt usually with payable interest that delivers meaningful income.
Bonds also play a secondary role during market declines. Investors can take advantage of sharply discounted stock prices by selling some bond positions to purchase stock on sale. Therefore, a bond ETF could be sold, and a stock ETF purchased to rebalance. This action has been shown to reduce portfolio risk while providing a potential rebalancing bonus.
For many investors, ETFs are an excellent investment, but it’s necessary to take your time in reviewing whether an ETF is a good fit for your portfolio approach. Also, investors should be clear about their buy-and-hold strategy to avoid getting into the habit of regularly trading in and out of different ETFs. Doing this is likely to lead to poor results even when trades are free and if you want to find out more on stock markets, check best forex trading platform Australia to learn about Forex trading.
