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What is an ETF?

An exchange traded fund (ETF) allows investors to buy and sell a bundle of securities, such as stocks and/or bonds, in a single transaction. In this way, it is conceptually similar to a mutual fund. However, an ETF is traded on an exchange throughout the day, like a stock is traded.

Conventional mutual funds are only traded once, at the end of the day. Simplistically, at the of the trading day, all the securities (stocks, bonds, etc) are added up and a mutual fund unit price is determined. ETFs do the same thing, effectively but throughout the day.

The first ETFs mirrored various passive equity and bond market indices weighted by market capitalization. (Such as the TSX or the Dow Jones or S&P 500) So returns would effectively be the index return less the ETF's much smaller management fee.

ETFs have exploded in popularity for a couple of reasons.

  1. Their management fee often is much less than a mutual fund which, in theory means more of the return is sent to the investor.

  2. Related, many of the conventional mutual funds do not perform well in comparison to their asset class indices.

Why do ETFs have much lower fees than a mutual fund?

Traditional ETFs have much lower fees because there is no human manager or management team researching, selecting individual investments (stocks, bonds, etc) so where an index ETF mirroring the S&P 500 would have -obviously- 500 securities, a typical management team we work with would hold 30-50 different businesses.

More recently, ETFs using enhanced indexing strategies – referred to as strategic or smart beta indices – have experienced strong asset growth. These strategies select and weight securities using fundamental or factor-driven methods, rather than the marketcapitalization approach used in a traditional index. More recently, actively managed ETFs allow investors to harness the investment expertise of professional money managers with a goal of providing outperformance and/or reduce risk, much like active mutual funds.

There are three main types of ETFs:

  1. Index (Passive)

    These track a corresponding market index and are designed to simply replicate the index's performance. These are the oldest and cheapest type of ETF.

  2. Strategic Beta

    These types use alternative index construction rules capturing perceived investment factors or market inefficiencies. In effect they create their own 'index' based on factors they believe have a higher chance of creating a better investment experience. They are essentially 'semi-active.'

  3. Active

    Closest to regular mutual funds, active ETFs have a full investment team making decisions on the underlying portfolio allocation. They have investments goals like being able to outperform a benchmark or provide greater diversification and/or reduce volatility, etc.

Which is better?

My personal experience (and bias) based on thirty plus years of working with clients is that the active management style -when carefully and responsibly chosen AND consistently reviewed- overall provides a better experience. This does not mean the teams we work with will always -or ever- outperform their representative index (though that sort of track record is important and considered when we are choosing management teams.) This is not our only consideration because of one key issue I see play out time and time again:

A large majority of individual investors underperform their investments.

This is because human nature, being what it is, wants us to sell what has gone down and buy what has gone up. So, without an advisor, many investors will constantly erode (or erase) their investments by making panicked or greedy short term decisions. The main tool we use to help our clients on the investing aspect is information.

So, for us, a key component of what we judge to be a good money manager will be their willingness and ability to provide reasonable, researched information. This can take various forms:

  • Why they are selling/not buying a currently popular stock or sector.
  • Why they are not selling/buying an currently unpopular stock.
  • What is going on in the stock market and the economy both at home and around the world.
  • How they think things will play out.
  • How they are responding to a current economic, political, tax, social situation.

This amount of information can be very useful when helping a client stay invested or make new investments or agree to get out of or scale back an investment. It gives both myself and the client more in-depth information and perspective, both of which can save the client from making an emotional, irrational investment decision.

And, in the end, helping a client achieve her financial goals is more important, more significant than simply helping her 'beat the index.'