Exchange-traded funds have a lot going for them. They offer both the instant diversification of mutual funds, and the cost-effectiveness of stocks. But because they are a relatively new product, there is still a lot of confusion regarding how they are bought and sold.
One of the factors that makes ETFs an attractive low-fee option is that they are not sold through the adviser channel. That means ETF administrators don’t have to pay as much to market their funds, and they don’t have to pay sales commissions to advisers. But that also means that you’re often on your own when you buy and sell them.
Luckily, buying and selling an ETF is as easy as buying or selling a stock. As with stocks, ETFs trade on all the major exchanges, such as the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE). The main difference is that when you buy or sell an ETF, instead of trading a single stock, you’re trading a fund which can hold dozens or even hundreds of stocks. So you’re effectively trading a basket of stocks at once.
As with stocks, the prices of ETFs change throughout the trading day, while mutual funds are usually priced only once at the end of each day. And similarly to stocks, you make or lose money on ETFs depending on how their price changes while you hold them. If you buy an ETF for a higher price than you sell it for, you lose money. If you sell for more than you bought it for, you make money.
To buy or sell ETFs, the first thing you need to do is open a brokerage account. You have two options: a full-service brokerage or a discount (self-service) brokerage. The full-service brokerage offers personalized service and advice from a client manager, but you pay higher trading costs of approximately $90 per trade, plus commissions. A discount brokerage account lets you buy and sell ETFs (as well as stocks, bonds and mutual funds) online or by phone.
While there are no advisers to help you, the trading commissions are low, in the $5 to $29 range. The major online discount brokerages include Scotia iTrade, Questrade, CIBC Investor’s Edge, QTrade, TD Waterhouse, RBC Direct Investing, and BMO InvestorLine.
Once your account is up and running and you have deposited funds, you can start trading, but remember: every time you buy and sell an ETF you’ll incur a fee. If you have a small account, brokerage commissions can erode an ETF’s low-expense advantage, explains David Vomund, author of ETF Trading Strategies. For that reason ETFs are not ideal for portfolios worth less than $30,000, or for investors planning on using a dollar-cost averaging strategy, where you invest a fixed amount at regular intervals, such as every month. The good news is that the trading commission is usually fixed, so the higher the value of the trade, the lower the percentage cost. Because of that, ETFs are an excellent low-cost option for investors with larger portfolios.
Tools of the trade
Because ETFs trade like stocks, you can access many of the tools that stock traders use when placing orders. These can help you lock in gains and limit losses — advantages inherent to stocks but missing from mutual funds.
For instance, a “limit order” allows you to buy a certain number of units of an ETF at a specified price — a useful strategy when trading a low-volume ETF or in a highly volatile market. Using a limit order is a good idea if the ETF has a wide bid-ask spread — meaning a large gap between the buyer’s offer and the seller’s asking price. (For more on different trading orders and how to use them, see our ETF trading cheat sheet.)
However, most buy-and-hold ETF investors are interested in the larger, highly liquid ETFs. If that’s the case, simply selecting the right funds for your portfolio and using the default trading order — a market order — will be just fine, says Richard Ferri, CEO of Portfolio Solutions, and author of The ETF Book.
Narrowing the field
There are more than 200 ETFs trading on the TSX, plus hundreds more available to Canadians on U.S. exchanges. Finding the ETF you’re after in such a crowded marketplace can be daunting, but there are online tools that can help. To help sort and filter ETFs, it helps to think of them as falling into three broad groupings: passively managed, actively managed, and screened.
If you’re just starting to use exchange-traded funds, passive ETFs are the easiest to understand. They simply attempt to replicate an index that tracks a broad market or specific sector, such as the S&P/TSX 60, the S&P 500, or the S&P/TSX Global Mining Index.
Actively managed ETFs, on the other hand, are not much different from traditional mutual funds: they employ fund managers who select individual securities they think will outperform the market. Such an ETF may specialize in dividend stocks, for example, but it might also hold cash and bonds if the manager chooses.
Screened ETFs — sometimes called strategy ETFs — fall somewhere in between. They start with a broad index, but then filter out securities that do not meet certain criteria. For example, an ETF may use a methodology that selects only companies which have increased dividends over the last five years, or it may alter the weighting of stocks in the portfolio according to certain rules.
To help you screen funds that meet your investment criteria you can use online tools, such as the Toronto Stock Exchange’s ETF Screener. (See Zeroing in on the right ETF for you, for a list of useful tools.)
If you’re a buy-and-hold investor, and you want the widest possible diversification, you should stick with broad-market ETFs for the core of your portfolio, says Ferri. Then you can branch out and add an ETF or two that concentrates on a specific sector.
Know the risks
Even though ETFs offer instant diversification, better tax efficiency, and transparency (in both holdings and investment strategy), as with all investments, there are risks.
You should keep in mind that studies show that the typical individual investor has a poor record when it comes to timing the market. Since ETFs can be bought and sold throughout the day, there is a danger that you’ll be tempted to trade too frequently. “The potential to undermine yourself with trading is very real, and you don’t have to trade a whole lot in order to sabotage a good ETF investment,” explains Morningstar analyst Dan Culloton.
Inexperience with online trading platforms can cause problems, too. To avoid costly errors, Ferri strongly suggests familiarizing yourself with the types of trades and orders used on stock exchanges.
Another tip, says Ferri, is to avoid trading when the market is highly volatile. On these days an ETF’s intraday price can fluctuate quite rapidly. You’ll also want to avoid buying or selling on the tip or the tail of the trading day, says Ferri. “It’s called the ‘smile’ in the ETF world, because the price deviation of the ETF can be the greatest during the start and end of the trading day.”
In the morning, ETFs are going through an adjustment phase — comparing the previous day’s closing price with the current NAV price, and, at the same time, factoring in changes to the value of the underlying stock. At the end of day (especially during the last hour of trading) large designated investors begin to hedge their positions, which can result in rapid pricing changes and wide bid-and-ask spreads.
For long-term investors, Ferri suggests sticking with funds that have a narrow spread between the bid-and-ask price and funds that have good liquidity. Ferri also suggests sticking with market orders — the default trading order — until you become more comfortable with the process. By keeping it simple and riding out market swings you can take advantage of the low fees and stable returns offered by most ETFs and create a well diversified, long-term portfolio.
Did you miss Part I of our ETF Advantage series? You can find it here.