I’ve written a few 101-type articles on investing in the past, including one piece explaining how a mutual fund works. Today’s piece will walk you through the mutual fund’s cousin, the Exchange Traded Fund (ETF).
How does an ETF work?
An ETF is both similar and different to a mutual fund. It is similar in the sense that ETFs typically are an investment that holds a number of underlying securities within them. For example, there are ETFs that mirror a particular index, ETFs that hold stocks from a particular country or sector, and ETFs that hold only bonds, among many others.
Similarities to a Mutual Fund
ETFs are also similar to mutual funds in that they charge a management fee (AKA the Management Expense Ratio, AKA the MER) to keep your money invested within them. This is because they occasionally need to buy and sell underlying investments on your behalf, and that person needs to get paid.
That said, the MERs for ETFs are often much lower (usually less than 1%) than mutual funds (which in Canada charge an average of around 2% of the value of your portfolio each year). This is because most ETFs aren’t “actively managed” – that is, they don’t have a money manager constantly watching the market and making trades to try and beat it.
Differences from a Mutual Fund
ETFs also differ from mutual funds in another important way. While mutual funds typically don’t charge a commission to buy the fund, they historically penalize you for withdrawing the funds before a specified date (often 5 or 7 years). This charge is called a Deferred Service Charge (DSC), and is meant to deter you from taking your money out before the mutual fund company has made enough money off of you. This approach has become more and more unpopular lately, and so this fee is starting to disappear… but it still exists.
Instead, ETFs charge a commission to purchase them upfront, exactly like a stock. If you were to purchase stock with the online brokerage of a big bank, you’d typically pay a $9.99 commission to do it. The same thing applies to ETFs. You pay to buy in, and you pay the same commission to cash out. It may sound like a lot, but when you’re dealing in thousands of dollars at a time, $10 represents less than 1% of the trade value.
Which is better: an ETF or a Mutual Fund?
The answer, as with most things in finance and in life, is that it depends. If you can only save a few hundred dollars at a time, or if your nest egg is fairly small, it may make sense to invest in mutual funds to start. That way, you’ll avoid paying the $10 commissions, which can really eat into your investment in your early years.
If, on the other hand, you’ve built up a sizable nest egg, ETFs may be the better way to go. You’ll save more money paying the $10 commissions instead of 2% of your investments each year.
Think of it this way: if you can save even 1% a year in MER fees (a conservative estimate), then on a portfolio of $100,000, you’re saving $1,000 a year. At $10 a trade, you’d have to make 100 trades in the year before ETFs start to look crappy against mutual funds. At $200,000, that figure doubles to 200 trades. See my point? The more you already have invested, the more likely it is that ETFs are the better way to go for you.
If you’re just starting out though, mutual funds are a great option. In fact, there are some index mutual funds that rival most ETFs in how cheap they are. In Canada, for example, TD’s E-Series index funds have some of the cheapest MERs in the country, as low as 0.30%. That’s a good deal no matter how big or small your nest egg is, and I have much of mine invested within their E-Series of mutual funds.
Wrapping it Up
ETFs can seem intimidating until you crack them open and see what’s inside. When you do, you realize that they’re not really all that scary. They hold individual stocks, bonds and other stuff just like a mutual fund, and can be a great way to diversify your investment portfolio without buying a bunch of individual stocks. As always, just make sure you do your research before buying!
