Ten years ago, there were only 10 companies that issued Canadian ETFs, and they were worth only $66 billion in total. Towards the end of 2023, Canadian-listed ETFs were worth $376.6 billion, an increase of almost 500%.
Despite this growing popularity, less is known about ETFs compared to stocks, bonds and mutual funds. In this article, we’ll look at how ETFs work, the types of ETFs available to Canadians, how much ETFs cost and whether ETFs are right for your investment portfolio.
What is an ETF?
An exchange-traded fund is an investment product that is like a basket of securities (which are different types of investments). They can often contain hundreds or even thousands of securities, from different asset classes (such as bonds and shares). They usually focus on a specific market, region or sector, and are similar in some ways to mutual funds).
For example, some ETFs contain all of the companies that appear in the S&P 500 Index (a list of the biggest companies in the U.S.), and some hold companies from developed countries in Europe, Australasia and the Far East (for example, MSCI EAFE Index ETFs).
The main advantage of ETFs is that they provide a convenient and very low-cost way of gaining diversification in your portfolio. Investing in this many stocks and bonds individually would be very impractical for individual investors: the costs of buying and selling these assets alone would make it untenable. Because ETFs are bought by thousands of individual investors (as well as large institutional investors, such as pension funds) the trading and management costs are shared and therefore minimized, making them very affordable.
How do ETFs work?
Investment management companies create ETFs following a specific strategy or mandate. This mandate can often be to replicate the performance of a specific index, such as the S&P 500 Index (mentioned above), the S&P TSX Composite Index (almost three-quarters of the companies listed on the Toronto Stock Exchange), or the Nasdaq Composite Index (almost all of the stocks listed on the Nasdaq stock exchange, which contains a high concentration of technology companies).
Increasingly, ETFs are becoming more sophisticated, with mandates that go far beyond replicating an index. For example, some of these ETF mandates could be to reduce volatility (and lose less value when markets dip) or deliver returns that are better than the market average.
Each exchange-traded fund is then given a ticker (a unique series of letters that are used for trading purposes) and listed on a stock exchange (or several). Investors can then buy units of the ETF, and its share price could change at any time over the course of the trading day.
The types of ETFs available in Canada
There are around 1,300 different ETFs listed on Canadian stock exchanges, and these are broken down into a wide variety of types. There are different ways of classifying ETFs, such as the type of assets, sectors and regions they focus on, and their management styles. Some ETFs could be a combination of several of these types (such as an index equity ETF). These are some of the most common types of ETFs available in Canada:
Index ETFs
Also known as passive ETFs, these ETFs typically try to copy the performance of a specific index, by holding companies that appear in that index. This could either be a very broad index, such as the Nasdaq or the S&P 500, or a more targeted index that focuses on a specific sector or asset class, such as the CSI 300 Index (comprised of the 300 largest companies traded on mainland China’s two biggest stock exchanges) or the Solactive Canadian Corporate Bond Index (which is made up of bonds issued mostly by Canadian companies).
Because there is very little active management required, these ETFs typically have the lowest costs and provide a very convenient way for investors to get broad diversification in their portfolio.
Strategic beta or smart beta ETFs
This kind of exchange-traded fund is designed to outperform traditional index ETFs by using a rules-based approach to how the ETF is constructed. This approach will determine which securities and how many of each to include in the ETF.
The rules’ objectives could be to deliver better returns than the ETF’s benchmark (the index against which its performance is compared), or to provide more stability than the benchmark (for example, the ETF will have less of a drop in value when markets dip).
Actively managed ETFs
These exchange-traded funds have a manager or team overseeing the construction of the fund and they often also monitor its progress, making tweaks along the way if there are any changes in the market, so the fund continues to deliver on its goals.
These ETFs give the fund managers more freedom in how the fund is made up, so they can improve its performance, for example, by replacing underperforming assets. However, because of the added and consistent input from the fund managers, these types of ETFs typically cost more than index ETFs.
Bond ETFs
This kind of ETF contains bonds, which are effectively loans made to governments or businesses. Bonds play an important part in the diversification process for investors’ portfolios, as they’re normally a safer and more consistent investment than equities (shares in companies).
In return for lending the government or company a specific amount of money, the investor is paid a percentage of the investment value in interest, which is often paid out several times over the year. The principal payment (the amount originally invested) is paid back after the bond’s term comes to an end. Bond ETFs can contain a collection of hundreds of bonds, which helps provide a portfolio with diversification and reduces the inherent risks of investing.
They can also be useful for those investors who need their investments to provide them with a regular income (such as retirees), as they can provide regular payouts.
Equity ETFs
These ETFs contain a collection of holdings from a wide variety of companies. Many equity ETFs are very broad ranging (such as holding the companies in the S&P/TSX Composite Index).
Others can be more specific, such as holding only a certain type of company (such as large cap companies — those worth over $10 billion), companies from a specific sector (such as information technology or energy) or from a specific region (such as Europe or emerging markets). Equity ETFs typically provide greater growth potential for your investments than bond ETFs but are also more vulnerable to market volatility.
Industry/sector ETFs
Some investors may feel that a specific sector or industry could be poised for considerable growth and want to broadly invest in it. An industry or sector ETF allows them to do this, by holding dozens or even hundreds of companies within specific sectors, such as the financial industry, health care and natural resources. Some of these exchange-traded funds allow investors to get very specific in targeting a sector.
Niche or thematic ETFs
Some ETFs allow investors to focus on a niche sector or a cause they’re passionate about. For example, there are ETFs that hold companies involved in the development of artificial intelligence, and others that contain holdings from companies that are at the forefront of promoting diversity in the workplace.
Sustainable ETFs
Sustainable investing has been growing in importance for some time now, as many investors want to be sure that the companies they invest in match their own concerns or worldviews.
Sustainable ETFs include holdings of companies that follow good ESG practices (they actively care for the environment, have strong social policies and diverse, transparent governance). Examples include ETFs containing holdings that are sustainability leaders, renewable energy companies or low-carbon companies.
What you should look for in an ETF?
Before investing in an ETF, there are several aspects that you need to research. Due diligence is essential to ensure that you invest in the right ETF for your particular circumstances, so that you choose the ones that will deliver the best results for you. Here’s what you should be looking for:
Trading volume: this tells you how often an ETF is bought and sold. While trading volume may be lower in more niche products, the higher the trading volume, the easier it will be to sell the ETF when that time comes.
Performance: as with any investment, you probably won’t want to invest in anything that has performed consistently badly. While past performance of an ETF may not necessarily predict its future performance, it should nevertheless be an important factor when you’re making a buying decision.
Cost: ETFs generally have low costs compared to mutual funds or trying to build a similiarly diversified portfolio with individual assets. However, if two otherwise identical ETFs have different expense ratios, it would probably make sense to go with the cheaper option.
Commissions: in general, many ETFs can be bought and sold with zero commission, so this is worth checking.
Holdings: seemingly similar ETFs can actually hold very different companies, so this is also worth exploring.
The advantages of Canadian-made ETFs
Canadian-based investors have the choice to invest in either Canadian-listed or foreign- listed (usually U.S.) exchange-traded funds. There are a few key advantages of holding Canadian ETFs, which are important to understand because they can have a considerable impact on the long-term growth of your investments:
Improved diversification: US-listed “international” ETFs often hold Canadian companies. If you’re a Canadian investor, this can skew your allocation towards Canadian investments, without you even realizing it. Canadian-listed international ETFs typically don’t hold any Canadian companies at all, which would help maximize your portfolio’s diversification.
Less impact from currency fluctuations: Canadians’ portfolios should contain international investments, so as to achieve maximum diversification. However, this can bring with it currency risk. For example, if, over the year, the Canadian dollar strengthened significantly against the U.S. dollar, any gains from American investments, such as U.S. bonds, could be reduced or even wiped out. Many Canadian ETFs are hedged against the U.S. dollar, which means that they won’t be affected at all by any currency fluctuations.
Reducing taxes: Many countries charge a withholding tax at source for dividends that are paid to overseas investors. If you have U.S.-listed international exchange-traded funds, you could end up paying withholding tax twice: once in the country where the companies reside and a second time in the U.S. Also, dividends received from companies outside of Canada do not receive a dividend tax credit, which dividends from Canadian companies do receive.
Canadian-listed ETFs don’t have to deal with the U.S. middle-man, so they come with considerably lower withholding taxes. This in turn means that your investments will grow considerably faster.
The pros and cons of ETFs
Given the growing popularity of ETFs among Canadian investors, there are clearly some great benefits to including these funds in your portfolio. And when it comes to ETFs versus mutual funds, ETFs can offer some distinct advantages. However, as with all investments, there are also some potential drawbacks that you should be aware of.
Advantages of ETFs:
- Cost-effectiveness: ETFs allow you to invest in hundreds of companies at a fraction of what it would cost to buy and sell shares in these companies individually. ETFs also typically have lower management costs than mutual funds and low-to-zero broker commissions.
- Immediate diversification: ETFs are available in a very broad range of industries, company types and sizes, and regions/countries. Investing in just a few ETFs can provide immediate diversification.
- Flexibility: most ETFs don’t have minimum investment levels (unlike mutual funds), so they’re an investment that is more accessible to more people. Also, some mutual funds have minimum investment periods, within which you can’t sell the funds without paying a penalty. This isn’t the case with ETFs.
- A longer trading window: ETFs trade on stock exchanges, so you can buy and sell them at any point during the trading day. Mutual funds can only be traded at the end of the day, after their price has been set.
- Potentially lower capital gains tax: many ETFs are passive index funds, which means they’re designed to replicate an index’s performance. Therefore, they don’t trade in the underlying assets as much as many mutual funds, so they don’t trigger taxable events as often, which in turn can reduce the taxes that need to be paid.
Disadvantages of ETFs:
- Focusing on niche ETFs can reduce your portfolio’s diversification.
- The fast rise of ETFs’ popularity means that some funds can have low trading volumes, which can make them hard to sell.
- Actively managed ETFs tend to have higher fees than index ETFs.
ETF FAQs
How much do ETFs cost?
This all depends on the type of ETF you invest in. Index ETFs can have a management expense ratio (MER) as low as 0.04% (an ETF’s MER is a combination of the costs involved in managing the fund, expressed as a percentage of the amount invested). Actively managed ETFs can be considerably more expensive, depending on the amount of input required from the fund managers, and can have an MER as high as 0.75% or above.
You may also have to pay a commission when buying or selling ETFs, though many brokerages offer zero-dollar trades. And the ETF’s bid/ask spread and its premium/discount to its net asset value can add to the costs of owning an ETF.
Can I have ETFs in my RRSP?
You can indeed hold ETFs in an RRSP (as well as in other registered accounts, such as a TFSA, RRIF and RESP), as long as the ETF is listed on a designated stock exchange (such as the Toronto Stock Exchange, New York Stock Exchange and Nasdaq).
What’s the difference between an ETF versus a mutual fund?
The main difference is that exchange-traded funds are bought and sold during the trading day, on stock exchanges. Mutual funds can only be bought at the end of the day, at market close prices. Also, mutual fund management costs are traditionally higher than those of ETFs because they’re typically more actively managed, overall, than ETFs. Mutual funds typically have constant input from professional fund managers (though the more sophisticated [and pricier] ETFs can also have this).
Mutual funds typically have minimum investment levels, while you can buy a single share of an ETF. ETFs are also usually more tax efficient than mutual funds because they generate fewer capital gains.
How much should I invest in ETFs?
This will very much depend on what investments you already have in your portfolio and your individual investment goals. A good financial plan will include the most appropriate investments for you to hold, taking into account your goals and your appetite for risk, and this could include ETFs.
How do you make money with ETFs?
Depending on what kind of ETF you invest in, you could make money from interest (if the ETF holds bonds), dividend payments or capital gains (the increase in value of your investments), or potentially all three at once.
What is an ETF’s index?
Most ETFs try to replicate a market index, which is a hypothetical collection of investments that represents a specific segment of the stock market. These indices are created and managed by companies such as Standard & Poor (S&P), Dow Jones and Morningstar.
Some of the most famous market indices include the S&P/TSX Composite Index (which represents around 70% of the value of all companies listed on the Toronto Stock Exchange), the S&P 500 Index (the biggest companies in the U.S.) and the Nasdaq Composite Index (which represents the entire Nasdaq Stock Market).
Which ETFs are right for you?
This will depend on your investment goals, risk tolerance level and overall financial plan. Before investing in an exchange-traded fund, you should thoroughly research it to make sure that it’s worth the expense fees and that it will help you achieve your financial goals. There are some questions you can ask yourself before investing in an ETF, such as:
- Are the sectors or regions held in the ETF underrepresented in your portfolio?
- Is the ETF’s risk level on a par with your own?
- Does the ETF suit your investment timeframe?
A financial advisor will be able to recommend the right ETFs to fit into your portfolio and help you achieve your financial goals.
How do you invest in ETFs?
You can buy ETFs through a traditional or online investment brokerage. You may also be able to buy ETFs through your financial advisor. Buying through your advisor will also give you the added benefit of having the ETFs fit into your overall financial plan.
A comprehensive financial plan takes into account every aspect of your financial life, including cash management, savings goals, retirement planning and the investments that will get you there. Your financial planner will recommend the most suitable ETFs to help you achieve your financial goals faster and ensure that they fit in seamlessly with the rest of your portfolio.
Talk to an IG Advisor today to discuss how ETFs could boost your portfolio. If you don’t have an IG advisor, you can find one here.
Written and published by IG Wealth Management as a general source of information only. Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice. Seek advice on your specific circumstances from an IG Wealth Management Consultant.
Commissions, fees and expenses may be associated with mutual fund investments. Read the prospectus before investing. Mutual funds are not guaranteed, values change frequently and past performance may not be repeated. Mutual funds and investment products and services are offered through Investors Group Financial Services Inc. (in Québec, a Financial Services firm). And Additional investment products and brokerage services are offered through Investors Group Securities Inc. (in Québec, a firm in Financial Planning). Investors Group Securities Inc. is a member of the Canadian Investor Protection Fund.
