ETFs: a cheaper, smarter way to lower investment risk – while maximizing returns
Among the advantages of Exchange-Traded Funds: They can have significant stock holdings in many different companies, thus diversifying your investments
A common question is: “Just what is an ETF?” A simple way of replying is to explain that, with Exchange-Traded Funds, you can trade shares of a mutual fund on the stock market.
An ETF has been a type of an investment option since the early ’90s. It was Harry Markowitz who revolutionized investing at that time by offering a different way for financial advisors to manage various retirement accounts. Markowitz, who won a Nobel Prize for his work, developed a concept called the modern portfolio theory. Up to then, the general investing ideology was to invest in certain stocks, hoping to find a winner – while avoiding very much risk.
Following Markowitz’s theory, ETF funds own large investment portions of stocks, bonds and real estate. These investments are managed by a fund manager, then sliced and sold to individuals who can purchase them on the exchanges. Today the assets held by ETFs amount to more than $3 trillion.
Investopedia defines an ETF as: “a fund that tracks a specific index, specific asset or basket of assets to which it is pegged.” Like securities on the stock exchange, ETFs are traded, bought and sold throughout the day. ETFs cover many aspects of the market, including stock indexes, market sectors, commodities, currencies, bonds and even instruments that track the volatility of the stock market.
To an experienced eye, ETFs might appear similar to mutual funds, as they both involve a pool of assets. However, the way in which they operate varies quite significantly. One of the main differences between the two is the way unit prices are calculated. With ETFs, the price fluctuates with the ebb and flow of the regular stock market trading sessions – unlike mutual funds, in which the asset value is calculated at the end of each day of trading.
Confused yet? Don’t worry, we can keep this simple. Look at ETFs this way: They are as flexible as if you were investing in individual stocks, while being as diverse as a mutual fund. If you are a savvy investor, and have the time that is needed for research and strategy, then certain stock portfolios may be an appropriate investment vehicle. Instead of investing in individual stocks, you can purchase an ETF that has significant stock holdings in many different companies, thus diversifying your investments. Your ETF can be viewed as tracking that specific market. The dividends from the companies the ETFs hold positions in are collected; then those profits get passed to you, the investor.
THE ADVANTAGES OF ETFS
Through investing in ETFs, you get the diversification that index funds offer. As well, you have the ability to sell short, buy on margin and purchase as few or as many shares as you prefer. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. If you buy and/or sell your ETFs, you pay the same commission to your broker that you’d pay on any regular order. Lastly, the potential exists for favorable taxation on cash flows generated by the ETF for holdings that fall outside of registered plans, such as Retirement Savings Plans (RRSPs) and a Tax-Free Savings Accounts (TFSAs). That’s because capital gains from sales inside the fund do not pass to the shareholders as they commonly do with mutual funds.
Due to the fact that ETFs are totally diversified, your likelihood of a major gain is smaller than if you buy shares in a single stock. However, the chance of you being exposed to an expediential loss is also much less likely.
Before the advent of ETFs, the norm of investing was to look at an individual stock and hope to find a “winner.” The problem was, this didn’t mitigate risk.
Of course, stocks are by nature risky! What Markowitz pioneered was the idea of diversification. The advantage of the diversification approach is that, in betting on a bigger piece of the economy, you’re taking advantage of those winners – while protecting yourself from unwarranted risk.
Similarly, today’s modern portfolio of mainly ETFs and mutual funds has a basic aim: Minimize volatility and maximize profits.
Hopefully this has been informative and provided you with some clarity on this topic. To see how we can help you with your investments, contact us at 604-688-5262 or email us at info@ciccone-mckay.com
