How to pick ETFs?
If you’re a new investor, with a small amount of money to start investing, it can be overwhelming to just think about all the investment options!
ETFs are a popular solution for this conundrum and can provide a great(and cheap) way for beginner investors, and investors who don’t have a lot of time to invest in the stock market.
What is an ETF?
An ETF or Exchange Traded Fund is a collection (or basket) of stocks, that is traded on the stock exchange. ETFs trade the same way as regular stocks.
The ETF might track (or replicate the returns of) an index, a commodity, or any other asset. The idea is that you as the investor, rather than having to purchases all of these different stocks, can now buy a portion by purchasing one (or several) shares of the ETF.
Each share of the ETF now reflects the price of owning a portion of that basket of stocks or assets.
Benefits of investing in ETFs
There are 3 main benefits of investing in an ETF:
Since an ETF is like owning a part of a basket of many stocks, it is a great way to get exposure to the broader stock market.
Rather than investing in only one company, an ETF gives you have the option to instead buy portions of several stocks (for a fee of course).
TWO: Lower cost
Many popular ETFs are passively managed. This means that the ETF tracks the index and tries to replicate the return of an index.
Some popular ETFs that track an index are SPY, which tracks the S&P 500, or the QQQ, which aims to replicate the returns of the NASDAQ.
As an individual investor, this means that you get the benefit of owning all the stocks on the index, without actually buying all the stocks that are part of the index.
THREE: Passive Income
Many ETFs pay out dividends, which can be a great way to build out a passive income stream. The dividends would be from several companies, but you won’t have to individually purchase ALL the stocks of those companies.
What to look for when purchasing an ETF?
ETFs, especially passively managed ETFs, tend to have lower fees than mutual funds. This provides an advantage to you as the investor, by allowing you to access the same investments, at a lower cost.
Fees can be as low as 0.2%, which is a lot lower when compared to mutual funds, which average about 2% in Canada.
Investing Style: Active or Passive
An ETF can be actively or passively managed.
A passively managed ETF is one that is only trying to replicate the returns of the benchmark or index that it is tracking (not beat it).
For example, if you are invested in an ETF that tracks the S&P 500 (such as SPY), you can expect that the returns from the ETF will be identical to you investing in all the 500 stocks of the S&P (net of fees).
An actively managed ETF on the other hand means that there is a portfolio manager that is frequently trading the stocks within the ETF.
The goal of an actively managed ETF typically is to beat the market index it is tracking.
Actively managed funds tend to be more expensive, as the fund manager is compensated for the active management. The jury is still out on whether actively managed funds return more than passively managed funds.
Which index is it tracking?
Most ETFs have a mandate or are trying to replicate a specific stock market index or commodity. Knowing which index the ETF is tracking can be useful in understanding the types of holdings the ETF might have in the future, especially if you’re focusing on diversification strategies.
While you’re at it, you can also take a peek at the current top 10 holdings for that ETF to understand the type of stocks it holds.
How did it perform compared to the benchmark?
Now that you know which index the ETF should be tracking, it might be useful to compare the performance of the ETF against the index it is tracking (or the benchmark).
For example, if the index is supposed to track the S&P 500, but has consistently underperformed the S&P (after accounting for fees), it’s not doing a very good job of tracking the index or replicating its return.
How to buy an ETF?
ETFs are traded on the stock exchange like other individual stocks. ETFs can be purchased through your brokerage account.
If you invest using a Robo-Advisor, like Wealthsimple, they invest in many ETFs, so you’re now likely invested in a basket of ETFs.
Brokerage accounts are typically offered through the bank or online brokers, such as the big banks, Wealth Simple, or Questrade in Canada.
They will typically charge a commission to trade the ETF, both when buying and selling.
One thing to consider when investing in ETFs is the type of account you purchase your ETF.
Canadian Specific Thoughts:
In Canada, broadly, you could have an account that is
- Registered as RRSP
- Registered as TFSA (tax-free savings account)
- Non-Registered account — no tax exemptions.
When purchasing an ETF in a brokerage account, it is important to understand the tax implications of your gains or losses.
For example, within the TFSA capital gains are not subject to taxes, but US dividends are still subject to a withholding tax. If you are holding an ETF that pays only US Dividends, then the TFSA may not be the ideal spot for your investment.
An ETF is a great investment tool for beginners, and for those who want to have a relatively hands-off strategy with their investments. While it may be a relatively passive investment, it is still important to understand how ETFs work, and how they fit into your overall portfolio.
Originally published at https://mintandgoldstory.com on April 30, 2021.