ETFs (exchange-traded funds) are becoming more popular among investors as a way to diversify their holdings. If you understand the risk/reward trade-offs, you might want to look into it.
A pool of assets whose shares are traded on a stock market is known as an exchange-traded fund (ETF). They combine the characteristics of stocks, mutual funds, and bonds with their prospective advantages. ETF shares vary in price during the day based on supply and demand, much like individual equities. ETF shares, like mutual fund shares, are part of a professionally managed portfolio.
The only difference is that using Exchange Traded Funds, you save time and grow your money without the complexity of searching and managing stocks.
Types of ETFs
ETFs come in a variety types, each with a distinct investing objective. Some of the most popular ETFs are listed here:
- Diversified passive equity exchange-traded funds (ETFs) are designed to mimic the performance of prominent stock market indices such as the S&P 500, Dow Jones Industrial Average, and MSCI Europe Australasia Far East (EAFE) indexes. ETFs that follow major indexes have a track record of closely mirroring their performance benchmarks.
- By providing specialized exposure, niche passive equity ETFs, such as those that track S&P 500 sector subgroups or Russell 2000 small firms, can help investors fine-tune their portfolio approach. Like diversified passive funds, these specialist portfolio funds are usually made up of the same equities that make up their reference indexes.
- Active equity ETFs, rather than being tightly correlated to a benchmark index, let its managers to use their own judgment when selecting assets. Active ETFs have the potential to outperform the market, but they also carry a higher level of risk and expense.
- Fixed-income exchange-traded funds (ETFs) invest in bonds rather than equities. Major fixed-income ETFs are often actively managed, although their portfolios have low turnover and are generally stable.
Advantages of the ETF
- It has low expense ratios
- It has a big potential tax efficiency
- Low expense ratios
- There is no minimum investment dollar amount
- It can be sold short and bought on a margin
When ETFs Might Be a Better Option
When there is a smaller dispersion of returns from the average, you may want to consider ETFs. Essentially, ETFs may be a better option if individual stock performance is fairly consistent across the sector.
Utilities and consumer staples are two industries that fit this description. Instead of trying to pick stocks, you might be better off deciding how much of your portfolio to allocate to these sectors via an ETF.
Consider whether the risk of owning individual stocks outweighs the potential return. It’s no secret that risk and reward are inextricably linked. As an investor, you should demand a higher return if you are willing to take on more risk. However, if the dispersion of returns from the average is small (as in consumer staples and utilities), it makes more sense to have exposure to the entire sector rather than trying to pick a couple of lucky horses.
Another industry where ETFs may be a better option is the biotech sector. Companies rely on FDA approval for the sale of a new drug, and if that approval is not obtained, the company’s performance may suffer in the long run. However, if the FDA approves the sale of a new drug, investors may be richly rewarded. When the success of your investment is highly dependent on the approval of an organisation, it may be in your best interest to purchase the biotech ETF instead and participate in the gains of the entire industry, rather than just one stock.
Top ETF on the Canadian market
These are some of my most favorite ETFs that you can find on the Canadian market:
XDV: XDV aims to offer long-term capital growth by attempting to replicate the Dow Jones Canada Select Dividend Index’s performance, net of expenditures. XDV will primarily invest in Canadian equities securities in normal market conditions.
VDY: VDY is a Canadian ETF that invests in dividends. It only invests in the Canadian stock market. VDY’s goal is to match the performance of the FTSE Canada High Dividend Yield Index, which is made up of high-yielding Canadian equities.
XEI: XEI aims to offer long-term capital growth by attempting to replicate, as closely as feasible, the S&P/TSX Composite High Dividend Index’s performance, net of fees.
ZDV: The BMO Canadian Dividend ETF (ZDV) was created to provide investors with exposure to a yield-weighted portfolio of dividend-paying equities in Canada. To invest in Canadian stocks, the Fund employs a rules-based methodology that takes into account the three-year dividend growth rate, yield, and payout ratio.
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