Exchange-traded funds are diverse, flexible and cost-effective.
The COVID-19 pandemic prompted many investors to look more closely at their investments – and made it clearer than ever why it’s important to know what you own and understand how it works.
Many portfolios include exchange-traded funds (ETFs). In fact, as of July 31, 2020, Canadian ETFs had attracted a total of $230.6 billion in assets, spread across 811 funds from 36 firms. One of the reasons ETFs are popular among investors and their advisors is that, as the sector has grown, so has its diversity. That means ETFs can be put to work to achieve a range of objectives within an investor’s portfolio.
An ETF trades on an exchange – just like an individual stock. That makes ETFs very easy to buy and sell, and it also means they are priced throughout the trading day (unlike a mutual fund, which is priced only at the end of each trading day).
ETFs also generally offer:
Low fees because they have lower operating costs
Transparency, with holdings reported every day
Potential tax efficiency when portfolio turnover is low
Keep in mind that the savings associated with low fees and tax efficiency are magnified over time. So investors benefit the most from these features when they hold ETFs for the long term.
Three types of ETFs
The first ETFs, introduced in Canada 30 years ago, were structured to replicate the returns of a specific index. Instead of actively choosing investments, the managers of these early ETFs set them up to match the holdings of the indexes they were tracking. They were “passively managed,” simply matching the index without trying to outperform it.
Today, passively managed ETFs continue to deliver low-cost exposure to specific areas of the market. Depending on the index tracked, these ETFs may hold stocks, bonds, commodities, currencies, options or a blend of assets.
With an actively managed ETF, a portfolio manager carefully selects individual stocks, bonds or other assets, just as he or she would for an actively managed mutual fund. The difference is that the portfolio is structured as an ETF with all an ETF’s benefits, including low fees and potential tax efficiency.
As with any actively managed investment, the goal is generally to beat a benchmark index – which is something a passively managed investment, by definition, cannot aim to do.
Strategic beta ETFs, also known as factor-based ETFs, mix elements of passive and active management. They’re passively managed in the sense that they apply specific rules to determine what holdings to include in the portfolio. However, the rules themselves favour certain types of securities or holdings so that, as with an actively managed ETF, strategic beta ETFs have the potential to outperform their benchmark index.
A strategic beta ETF may give preference to value stocks, growth stocks, low-volatility stocks or any other group of assets that can be clearly defined. With a rules-based approach, performance does not necessarily depend on the manager’s day-to-day decisions but rather on disciplined adherence to the factor model, which offers two advantages. First, even professional money managers can be subject to the behavioural biases that affect all investors, and that may diminish returns. Second, less hands-on involvement generally means lower fees.
Incorporating ETFs into a portfolio
Different types of ETFs can be combined in many ways to achieve specific goals. For example, passively managed ETFs can provide broad market exposure or target a narrow part of the market an investor wants to emphasize, such as dividend-paying stocks or short-term bonds. Actively managed ETFs can enhance a portfolio by adding a skilled manager’s expertise and the potential for index outperformance – and active oversight may be especially important when markets are volatile. Meanwhile, strategic beta ETFs are a solution that an investor may use anywhere in a portfolio in an attempt to increase returns and/or decrease risk by emphasizing characteristics linked to long-term outperformance, such as company size, relative price or profitability.
Your advisor can help you decide whether ETFs can contribute to achieving your goals, and which types will best meet your needs based on your life stage, investment time horizon and tolerance for risk. They can also recommend appropriate allocations to passively managed, actively managed and strategic beta ETFs. Just as importantly, your advisor can make sure you build a portfolio you understand, so you can have confidence in it.