TMXmoney

Benefits of Investing in ETFs

Quick and cost-effective diversification

ETFs provide a wide choice of investment options, including various sectors, asset classes, geographical locations and investment strategies. ETFs typically track the performance of a basket of securities underlying the benchmark index – the benchmark can be made up of individual stocks, bonds or other securities such as commodities. Therefore, owning a few ETFs can be a quick way to diversify one’s portfolio. Attempting to build a diversified portfolio by buying individual stocks, bonds and other investments can be more costly, risky and time consuming than diversifying with ETFs. For example, if an investor would like to have a diversified portfolio of stocks and bonds one could use a stock ETF and a bond ETF rather than researching, buying and managing a number of individual bonds and stocks.

Trading flexibility

ETFs trade on major stock exchanges around the world. When you buy or sell an ETF, you do so at the prevailing share price at that moment in the marketplace. Mutual fund purchases and sales, in contrast, are processed at the end of each trading day, based on their net asset value (NAV). Therefore, there is a risk that the mutual fund price can change between the time you decide to purchase or sell it, and the time at which the end-of-day net asset value (NAV) is calculated by the mutual fund.

ETFs are also designed to trade close to their underlying net assets value. This provides greater assurance that the price of the ETF will reflect the value of the underlying assets, although in certain market conditions this may not be the case.

Unlike mutual funds:

You can use a variety of share purchase and sale order types for ETFs such as entering a limit order or a market order, or purchasing on margin. You can also sell an ETF short.
On derivative markets, investors can also buy and sell options on some ETFs.
ETFs have no minimum investment requirements.

Performance

ETFs have the potential to outperform an actively managed mutual fund over time. Many studies have been conducted demonstrating that a minority of mutual funds outperform the return of an index. ETFs are an efficient way to realize index performance and a lower annual management fee.

Transparency

ETFs report their holdings every day and typically disclose the specific weighting of the constituents of the tracked index, which means you will know when the ETF has modified its position in a particular stock or other security. In contrast, most mutual funds report their holdings periodically - typically quarterly or semi-annually. You may not know for months if the mutual fund you own has substantially changed its holdings, their weightings or the overall investment style (i.e. – from growth to value). The transparency inherent in ETFs, coupled with the tracking of a set index, provides greater confidence that the ETF will maintain its original investment strategy.

Cost effectiveness

Like all funds, ETFs have an annual fee referred to as a management fee. But because ETFs are typically able to achieve lower operating costs, the fee charged by ETFs is generally lower than that charged by mutual funds, and certainly lower than the expense of holding physical commodities directly, making ETFs more cost-effective. Although the percentage difference between an ETF and a mutual fund might seem insignificant, the difference can substantially affect the return on the investment over a long period of time. The degree of cost saving needs to be measured against the brokerage commissions applicable when buying or selling ETFs.

Tax efficiency

ETFs are generally more tax-efficient than mutual funds because they rarely trigger capital gains. Not only is the turnover of the underlying portfolio lower - particularly with index based ETFs - thereby reducing the level of capital gains tax payable by the fund and its investors, ETFs have a unique tax - efficient "in kind" redemption process which minimizes taxes. The ETF holder generally pays a capital gains tax only when the shares are sold. Mutual funds, on the other hand, generate taxable gains even while the funds are still held.

ETFs as compared to building a balanced portfolio of individual stocks, can be tax-efficient and cost-effective in another way. Over time, the excess capital gains generated through buying and selling individual stocks, along with the brokerage commission fees for each transaction, can reduce the overall return of your portfolio.

Note that some ETFs also offer dividends or other distributions on a regular basis. These distributions are taxable if held in a non-registered account.

Lower volatility and reduced risk

The price of a stock can change dramatically throughout the day due to company news and other events. ETFs generally have lower price volatility than individual stocks due to their inherent diversity in more than one security. The overall price movement of an ETF is dependent on the movement of all the holdings in the fund. Should one or more holdings of the ETF experience price volatility, generally the other holdings in the fund (with less volatility) will moderate the ETF’s overall price movement. The lower volatility inherent in ETFs reduces portfolio risk for investors.