Tuesday, February 1, 2011

What Are ETF's?

ETF stands for Exchange Traded Fund.  When I wrote about my basic market timing model, I mentioned the purchase of an ETF which tracked the total stock market rather than a mutual fund.  Before I talk about ETF's I would like to talk, first, about the problems I have with mutual funds.

Most mutual funds are actively managed, where a fund manager decides what to include in the fund according to the prospectus which defines the types of investments to be held.  There are equity mutual funds, fixed income mutual funds, and money market mutual funds.  Many have sales fees, either when I buy, or when I sell.  They charge a management fee, and deduct certain costs from the returns they generate.  Mutual funds pay a commission to the person who sold me the fund.  While there are a couple of good reasons to buy a mutual fund, generally, the cost of doing so is the reason I am not a fan.  Just to be clear, I am not a financial advisor, or anything of the sort, either.  In a case of I can buy better, but I can't pay more, most funds, because of the expenses involved tend to under perform the market.  One's that outperform rarely do so for long periods of time.  Guessing which mutual fund to own is a bit of a mug's game.

ETF's, on the other hand, tend to mirror a particular index, or commodity.  Since there is usually nobody picking what to include and what not to (that has already been determined by the index), the charges to me for fund management are less.  What that also means is when the index goes lower, so does the ETF, by an equal amount.  There is nobody trying to slow the decline.

They are called exchange traded funds because the shares trade on a stock exchange in the same fashion as other stock equities.  When I buy shares in the fund, I pay a commission fee, instead of a sales charge.  The management expenses are deducted prior to the share's value being determined.  If my shares go up ten cents each, then that means I made ten cents after the fund company has taken their portion.

There is a difference between regular shares and ETF shares.  With regular shares I purchase shares in one company at a time.  With ETF's I buy a basket of shares (of whatever makes up the underlying index), or contracts based on commodities.  A few ETF's allow me to buy the actual underlying commodity itself, with the fund manager having to store it for me.

Another difference is one of supply and demand.  A company offers a number of shares in the company to raise money.  ETF's are bought and sold from a float which is for most purposes, practically limitless.  I do not need to be overly concerned with supply and demand, as those constraints apply to the price of the underlying index, or commodity.

For people who have not heard about ETF's from a financial advisor, it is likely because advisors do not make any money when recommending the purchase of an ETF.  They do when selling mutual funds, but not for ETF's.  Since they trade like stocks, purchasing ETF's is seen to be more for the sophisticated investor, and less so for the beginner.  To avoid full service brokerage fees, I also need my own discount brokerage account online.

When starting out, I looked at purchasing widely based ETF's which performed as closely to the actual TSX as possible.  Sector, and specialty funds came later only after I gained more experience.  Claymore, Ishares, Horizons, as well as many of the Canadian banks have ETF's which are bench marked to the TSX.

Again, learning to manage my own funds took a little time and effort, so I started by "paper" trading without plunking down any actual money, and then started very, very small.  By small, I mean no leveraged ETF's - ETF's that return a multiple of the underlying index (i.e.: two times, or three times) until I gained some experience and understood what they were and how they worked.

I can make more by earning higher returns from my investments, or better still, by simply avoiding many expensive mutual funds.


  1. This was a very thorough, helpful article. Thanks for sharing! :)

  2. Thanks, Jessica. I absolutely loved your idea that an ETF would be the result of a stock and a mutual fund falling in love and having a baby!


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