What are ETFs and why are They so Popular?

Exchange-traded funds (ETFs) have seen their popularity explode in recent years. In fact, there are now more than $6 trillion dollars invested in the global ETF industry. Investors around the world are flooding the ETF industry with money. Clearly, something special is happening here.

Full disclosure, I started investing in ETFs a few years ago once I educated myself about what they are. Before then, I invested in mutual funds and index funds. Many people have asked me about ETFs which is why I created this tutorial to help guide you.

What are ETFs?

As its name implies, an exchange-traded fund is an investment fund that trades on a stock exchange.

ETFs allow a large group of investors to pool their money and benefit from the oversight of a professional investment manager.

What stands out about ETFs is that most of them are passively managed. This means that instead of the portfolio manager making discretionary decisions about which investments to buy or sell, they rely on a rules-based system to give you broad exposure to certain investments.

Let’s consider an example. Imagine you wanted to invest in the technology sector because you believe in the potential of great technology companies like Apple (AAPL) and Microsoft (MSFT).

If you were to invest in an actively-managed investment fund, the portfolio manager would spend time trying to selectively choose the best technology investments.

A passive fund is different. The manager of a passive fund would either (1) invest in all companies within the technology sector or (2) choose certain companies according to a rule-based methodology.

Why are ETFs so popular?

ETFs are not necessarily a revolutionary investment vehicle. They simply took an old idea (the investment fund) and made a small change to it (making it trade on a stock exchange).

So why are ETFs so popular?

ETFs provide two advantages over their main competitor (mutual funds):

• They provide intraday liquidity
• They typically have lower fees

Let’s discuss each of these points in detail.

When you buy or sell an ETF, you have access to intraday liquidity. This means that you can sell the ETF at any point during the trading day.

While this seems like an obvious feature, investment funds have not behaved this way historically.

Mutual funds generally have once-per-day liquidity, which means that your sale of the investment fund will be executed according to its price at the end of the day.

Hedge funds (and other alternative investment vehicles) are even worse. Many hedge funds have monthly or quarterly redemption schedules, which means you can only withdraw money on specific dates.

They also frequently have “lock up periods”, which means that you must keep your money invested with them for a certain period of time before you can make a withdrawal.

The intraday liquidity provided by ETFs eliminates these problems. However, this intraday liquidity comes with a cost.

When used inappropriately, intraday liquidity can cause investors to make poor investment decisions. This can range from something as trivial as selling an ETF when it experiences a small loss to something as crazy as day trading levered ETFs. While intraday liquidity gives investors the option to sell their investments when they want, there can be many emotional decisions made which can negatively affect their portfolios.

The next reason why ETFs have become so popular is their low fees.

The difference is staggering. According to Morningstar data, the average Canadian equity mutual fund fee is 2.35%, while the top 100 Canadian equity ETFs have an average fee of 0.31% (individual fees ranges from .05% to 1.29%). These fees are commonly known as the management expense ratio (MER).

On a $10,000 portfolio, this means you’d pay $142 in fees to own the mutual fund and just $53 to own the ETF.

The numbers become even more serious with a larger portfolio size. Using the average fee structure outlined above and a $500,000 investment portfolio, you would pay $7,100 in fees to own the mutual fund and just $2,650 to own the mutual fund.

So why are ETFs so cheap compared to their mutual fund counterparts?

For starters, they have far less management overhead. This is largely because ETFs are passively managed. While an actively managed fund must pay for a team of research analysts that decide which stocks (or other assets) to invest in, this expense does not exist in passively-managed ETFs.

Overall, the improved liquidity characteristics and fee structures available in ETFs have led to tremendous growth in their assets under management. We explore this trend in the next section of this article.

How you can purchase ETFs

Now that you’ve seen the benefits of ETFs, you’re probably wondering how you can invest in them.

The first thing you’ll need to do is set up an account with one of the major brokerage firms.

In Canada, Questrade is the best place to buy ETFs because they provide no-fee purchases. This means you can buy ETFs with no trading commissions! Alternatively, many people setup an account with a discount brokerage associated with their bank. E.g. TD Direct Investing, BMO InvestorLine.

In the United States, there are more options available. Interactive Brokers, Charles Schwab, and TD Ameritrade are all examples of brokerage firms that allow you to buy ETFs at no cost.

Websites like ETFdb.com make it easy to search for ETFs that meet your investment criteria. If you’d rather not research your ETFs manually, you could always follow a model portfolio instead.

Robo advisors such as Justwealth, WealthSimple and RBC InvestEase are also options if you want to purchase ETFs, but they charge you an additional fee on top of the ETF MERs. This is cheaper than mutual funds but more expensive than going the DIY route.

How to manage your ETF investments

Typically, DIY investors use spreadsheets to help them track their returns and calculate trades when rebalancing or investing new money. Simply google “portfolio management spreadsheets” and you’ll find a slew of templates that you can use or repurpose to meet your needs. If spending time crunching numbers in spreadsheets isn’t for you, you can use a portfolio management tool such as Passiv.

Passiv works in tandem with your brokerage account to put your portfolio management on autopilot. It makes DIY investing easier to follow and will save you a ton of time. Thousands of DIY investors use Passiv to turn their brokerage accounts into their own personalized robo-advisor service.

Here’s how it works:

1. You sign up for a free account with Passiv
2. You connect Passiv to your brokerage account*
3. You create a target portfolio
4. Passiv will show you the trades you need to place at your broker to maintain your target portfolio. It will also send you emails whenever your portfolio drifts off target or new cash comes in.

If you upgrade to Passiv Elite you can simplify the process even further to have Passiv place those trades at your broker in a single click. Passiv Elite typically costs $99/yr but there’s a special promotion that makes it available for free to all Questrade clients in Canada.

*Passiv is currently integrated with Questrade in Canada as well as Interactive Brokers, TD Ameritrade, and Alpaca in the United States.

Final thoughts

It’s clear that ETFs have become popular over the years because they’re an easy way to diversify your portfolio while reducing your costs. Although ETFs are easy to purchase, you still need a strategy in place, so you don’t actively trade and ruin your long-term goals. Passiv is one tool that can help you create your own robo advisor while keeping your fees low.