What is an ETF?

If you are new to investing, you will find yourself swimming in acronyms. An important one is ‘ETF’, because they are a popular investment product.

ETF stands for ‘Exchange-Traded Fund’. The important word here is ‘fund’.

A fund is a group of investments combined into a single product. Common investments are company shares (stocks) and debt (bonds).

Diversification is central to investing. The goal is to reduce risk, so that if a single investment performs badly, that you have limited your loss. This means owning many different investments, such as shares of many companies. It is time-consuming and expensive to do this yourself. A fund allows you to make a single purchase, and achieve diversification. The popularity of ETFs is for this reason.

A comparison is that an ETF is similar to a meal-kit. A meal-kit is a single purchase with everything you need collected and ready for you. On the other hand, going to a grocery store involves the effort of selecting the correct amount of many different items to make a meal. While a meal-kit is more expensive than buying your own groceries, an ETF is much cheaper than buying investments one-by-one. Again, this contributes to their popularity.

‘Exchange-traded’ is how you buy and sell the product. ETFs are bought and sold on a stock-exchange, the same as purchasing any other stock. To buy and sell ETFs, you only need a brokerage account. This contributes to their popularity too, as the buying of ‘Mutual Funds’ is typically not as simple.

Now that you know what an ETF is, you should know there are thousands of ETFs available for purchase. Conveniently, you can build an investment portfolio buying one ‘single-ticket’ ETF.

ETFs can represent the following:

  1. Single-Ticket ETFs which represent an entire diversified portfolio in one product.
  2. Thematic ETFs which have investments with a central theme, such as green energy or artificial intelligence.
  3. Sector ETFs which have investments in a certain industry, such as banking or pharmaceuticals.
  4. Country/Geographic ETFs which have investments from a certain geographic area.
  5. Goal-based ETFs which have investments to meet a specific goal, such as monthly income.

This list is not complete, just know there is a huge variety available to investors.

The last thing to know are the costs to the investor:

  1. If you are buying and selling ETFs yourself, it can cost you a trading commission. You will pay this once when you buy or sell the product. The cost depends on your broker.
  2. ETFs have a fee which is a percentage of the ETF value. It is called the MER (Management Expense Ratio). This fee pays for maintenance of the fund, and profit for fund company (consider that the meal-kit company has costs to gather food and prepare your meal-kit, the fund company has costs to gather investments and prepare your ETF). This fee is not on your statement, because the price of the ETF itself includes this fee. When researching an ETF, the MER is always available to you so you can compare to other ETFs. Ultimately the MER reduces the growth of your investment, as it is money being paid to the fund company, so it is important to consider it in your investment decisions.

As you swim in investing acronyms, I hope this has been helpful for you to make informed decisions about your money.

Questions you might have:

A dear friend was kind enough to ask me some questions. Here are your answers:

Q: If ETFs are a convenience product like meal-kits, why are they cheaper than do it yourself? Unlike a meal-kit which is more expensive than do it yourself meal prep.

A: The analogy conveys that it is a ‘package’, but cannot be considered for the production costs. The costs of producing a meal-kit cannot be compared to the costs of managing an ETF. An MER for an ETF is typically a fraction of a percent, whereas the trading commissions and research to build your own portfolio out-weigh the MER by a magnitude.

Q: What is a brokerage account?

A: A brokerage account is an account you open at an investment broker, that allows you to buy and sell investment products such as ETFs. Examples in Canada would be Questrade and Virtual Brokers.

Q: So the higher the MER, the lower the rate of growth? So smaller MERs are better?

A: A higher MER does not mean a lower rate of growth, it only means that a greater percentage of your money will be paid to the fund company. Ideally a smaller MER is preferable to a larger MER, especially if the ETFs contain basically the same investments. Many ETF companies offer more or less the same ETF (e.g. a collection of Canadian banks) with a different MER.

It’s important to consider MER as only part of your decision, and not base your decision solely on MER.

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