Lesson ETFs 101

What are ETFs?

ETFs 101

ETFs (Exchange-Traded Funds) are a type of investment product that owns and manages an underlying basket of assets (equities, bonds, commodities, derivatives, etc.) and divides the ownership of those assets into individual shares.

When you buy shares of an ETF, you’re participating in the gains or losses of the underlying assets that are held within the ETF. If those assets overall increase in value, individual shares will typically rise as well, and investors will earn a profit. On the other hand, if the assets within the fund overall decrease in value, individual units will typically drop as well and investors will incur a loss.

Let's use an example:

Paul is looking to invest in the U.S financial sector as he’s confident that this sector will outperform the market, but he doesn’t want to commit to a single company. Furthermore, Paul isn’t interested in composing and managing his own portfolio of securities due to time and knowledge constraints.

Paul is looking for an investment that is diversified across a very specific sector, so he considers an ETF.

After researching professionally managed ETFs that focus on the financial-sector, Paul finds an ETF that consists of 50 stocks of different financial institutions operating in America. For the sake of simplicity, let’s say the overall performance of the ETF will be evenly tied to the performance of all 50 of those financial institutions. This gives Paul the exposure to the financial sector that he’s looking for with his desired level of diversification.

Because Paul’s selected ETF has shares of so many different companies in the financial industry, his investment is less likely to be exposed to swings than if he were to invest in a single company within that industry. This can be both a benefit and a drawback, depending on the circumstances: if the value of one of the companies instantly dropped to zero then an evenly-diversified stock would remain at 98% (assuming the other 49 remained the same), however if the value of one of the companies instantly doubled then the ETF would only be up to 102% (assuming the other 49 remained the same).

Regardless, if the overall performance of the financial sector climbs, then Paul will benefit, even if some of the individual financial institutions within the ETF are struggling.

Benefits of an ETF

There are many benefits of ETF investing, including:

  • Generally lower fees

    ETFs strip away the unnecessary layers of fees that typically plague other investments, such as mutual funds. Because they trade directly on a stock exchange, you do not have to pay added costs such as trailer fees, sales charges, etc.

  • Diversification

    ETFs typically invest in a basket of underlying companies, commodities, etc. So, purchasing an ETF lets you gain exposure to many different companies at once.

  • Dividends

    If the companies held within an ETF pay a dividend, the ETFs will pass the dividend onto you. There are also ETFs built entirely around the dividend payouts of fixed income products such as bonds or GICs.

  • Flexible investment options

    Investors can borrow funds (also known as buying on margin) to purchase ETFs. This is convenient for people looking to use leverage to their advantage. Investors can also short ETFs, profiting when the ETF declines in price.

Types of ETFs

There are multiple types of ETFs in the market, some are constructed to track certain stock indexes, sectors, bonds, commodities, currencies, regions. Here are some of the common types:

Index ETFs Index funds and attempt to replicate a specific index of securities. These often track stock indexes, such as the S&P 500 or the Dow Jones Industrial Average, but index ETFs can also track indexes for bonds, currencies, commodities, etc.
Stock ETFs Many ETFs invest entirely in stocks. There are a number of different types of Stock ETFs depending on the stocks it invests in, such as index ETFs for the stock market, sector-specific ETFs, and more.
Bond ETFs Bond ETFs, often referred to as fixed-income ETFs, consist of 100% bonds. Depending on the fund objective, this may include corporate, federal, or provincial bonds.
Commodity ETFs Commodity ETFs invest in a physical commodity, such as precious metals, agricultural products, or crude oil, through either investing in derivatives (such as options contracts) or through the purchase and storage of the commodity itself.
Currency ETFs Currency ETFs function similarly to commodity ETFs, tracking the performance of different currencies relative to each other through instruments such as held currencies, debt, and derivative contracts.
Cryptocurrency ETFs Many ETFs are actively managed, which means they are controlled by a fund manager who can make changes based on current market conditions.
Actively managed ETFs Many ETFs invest entirely in stocks. There are a number of different types of Stock ETFs depending on the stocks it invests in, such as index ETFs for the stock market, sector-specific ETFs, and more.
Inverse ETFs By using bullish derivatives, inverse ETFs are designed to earn a profit when the underlying basket of stocks it is tracking declines. Inverse ETFs often track either a specific industry, or an entire index.
Leveraged ETFs Leveraged ETFs are similar to standard ETFs, only they use debt and derivatives to increase the earning potential of the index, sector, or asset class that they track. Similar to buying on margin, leveraged ETFs introduce increased risk to create increased earning potential.
Asset allocation ETFs Asset allocation ETFs are designed to behave more like an entire portfolio rather than a specific basket of stocks. They often contain several other ETFs and are managed according to a certain asset allocation strategy, often providing both equity (through stock ETFs) and fixed income (through bond ETFs) in a single ETF.
Alternative ETFs These ETFs offer exposure to the alternatives asset class. There are various alternative classifications, including hedge fund, long/short, managed futures and a few others. Learn more about alternative ETFs in our Alternative ETFs webinar.

Many ETFs can fit into several of these types. For example, an asset allocation ETF will likely be actively managed, and a leveraged ETF might follow an index.

The variety of ETF types means that there will often be several suitable options for any given investment strategy. Always do your research so that you choose the best investments according to your own personal strategy and goals.

Please keep in mind that some ETFs, such as leveraged, inverse, and alternative ETFs, involve significantly increased levels of risk. Please do your research to make sure that the ETFs you choose are suitable for your own investment strategy and risk tolerance.

Note: The information in this blog is for educational purposes only and should not be used or construed as financial or investment advice by any individual. Information obtained from third parties is believed to be reliable, but no representations or warranty, expressed or implied, is made by Questrade, Inc., its affiliates or any other person to its accuracy.

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