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ETFs explained

Discover how ETFs work and what they can offer in our easy to understand guide.

ETFs, or exchange traded funds, offer a low cost, flexible way to access a professionally managed product which offers a range of securities.

How ETFs work

ETFs are a useful way for investors to gain exposure to the stock market, certain industries or assets, without the need for fund management or sector-specific knowledge.

ETFs are a type of investment fund that consist of a collection of other securities, like stocks, bonds, or commodities, and are traded like a stock on an exchange. In many cases, the fund's goal will be to follow, or track, an index, such as the S&P/ TSX Composite. This type of ETF is classified as an index fund. As they capture a broader cross-section of companies or sectors within an index, they’re seen as a simple way to diversify your portfolio.

Benefits of ETFs over mutual funds

ETFs are typically passively managed – you don’t pay for a fund manager to make trading decisions on your behalf.

This means ETFs can be cheaper than mutual funds – particularly those ETFs that are actively managed, as there’s no minimum amount to start trading.

And, unlike mutual funds, which can only be bought and sold for a fixed price at the end of each trading day, ETFs can be bought and sold throughout the day. This means more flexibility to make trading decisions yourself.

Benefits of ETFs over stocks

As we’ve mentioned, ETFs can be traded throughout the day, which means they offer similar trading flexibility to stocks, but with more diversification.

You can invest in a group of companies or sectors, or even track the performance of a whole market should you wish. This means you’ll get exposure to a wider variety of equities and market segments than trading in individual stocks alone.

ETFs at a glance

Potential upside Potential downside
Trading flexibility Short-term trading decisions may affect overall performance
No minimum investment Trading fees can mount up
Lower costs than active funds Lack of fund management
Easy access to global markets Diversification can be limited

ETFs at a glance

Potential upside Trading flexibility Trading flexibility
Potential downside Short-term trading decisions may affect overall performance Short-term trading decisions may affect overall performance
Potential upside No minimum investment No minimum investment
Potential downside Trading fees can mount up Trading fees can mount up
Potential upside Lower costs than active funds Lower costs than active funds
Potential downside Lack of fund management Lack of fund management
Potential upside Easy access to global markets Easy access to global markets
Potential downside Diversification can be limited Diversification can be limited

Types of ETFs

The growing popularity of ETFs among investors means there are many types to invest in, such as sustainable options, as well as those that track country or sector specific indexes.

Equities, or stocks

These track equity indexes, such as large businesses, particular sectors, or a single country or market’s index. If you want to invest in specific sectors, equities ETFs can offer access to that sector and could be a lower risk option than buying into a single company.

Beware of investing too heavily in one particular sector. If that industry suffers an unexpected downturn, such as the travel industry during the Covid-19 pandemic, you could experience fall in the value of your investment.

Bonds, or fixed income

To balance equity investments, you may use fixed-income and bond ETFs to diversity your portfolio.

Your portfolio’s ratio of equities and bonds should depend on your investment goals, risk tolerance and timeframe. The more weighted it is towards equities, the higher your risk and growth potential. The more it’s weighted toward bonds, the lower your risk-reward potential.

Commodities

Commodities are tangible, real world products like precious metals, oil, or even crops. Commodity ETFs make it simpler to invest in these types of products, which in turn may help to diversify your portfolio. ETFs don’t normally own the asset directly. They track the commodity price using an agreed upon security, known as a ‘derivative’. This can be riskier than investing in funds that own the commodity directly. It’s also worth noting some commodity prices can be more volatile than other securities, so consider your risk appetite before investing.

Currency or Foreign Exchange

Investing in currencies can be another way to balance your portfolio. So, if you’re invested in overseas markets, for example, you may want to ‘hedge’ your risk of the currency fluctuations by investing in more stable currencies, or those you believe might go up in value. Currency ETFs can be riskier if they invest in derivatives, so always be sure of what you’re buying.  

Sustainable or ESG (environmental, social and governance-led) ETFs

More investors than ever want to put their money in socially and environmentally conscious investments, which means sustainable ETFs are becoming increasingly popular. New opportunities could also emerge as the finance industry embraces ESG issues.

Investor takeaway

Whether you're an active investor wanting to make the most of day-to-day price fluctuations, or a passive investor wanting to invest more strategically and for the long term, ETFs offer a flexible, cost-effective solution.

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