Exchange Traded Funds Basics

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A few months ago, I talked about mutual funds and some of their drawbacks (the 2-3.5% yearly MER fee they charge for actively managing the fund), and how I personally prefer Exchange Traded Funds over mutual funds.

So what are Exchange Traded funds, you ask?

Exchange Traded Funds or ETF's for short (The acronym ETF makes it sound sexy, doesn't it?) are basically a mutual fund traded on the market… minus the hefty fees.  ETF's track the index.. but can be traded like a stock.  They are a collection or basket of stocks (each ETF has a company such as Vanguard, iShares, Claymore, and SPDRs… ).  On their websites, Vanguard, iShares, Claymore, and SPDR will show you which stocks are in the specific ETF you are looking at)– just like a mutual fund.  The major difference between a mutual fund and an ETF is that a mutual fund is actively managed– you are paying someone who went to school for a bazillion years big bucks to actively manage the mutual fund. By big bucks, I mean the higher MER.  By actively manage, I mean that the guy or girl with the cushy salary buys and sells equities within the mutual fund constantly.

You would think that active management is good, right?  WRONG.  Most mutual funds actually underperform the average return of the market.  AND when you own a mutual fund, you'll pay more in tax (like capital gains and income distrubution tax- you won't get that in an ETF).  A mutual fund passes its net gains to investors, not net losses.

Many people favour ETF's compared to individual stocks because you are hedged against risk because an ETF tracks a number of stocks, not just one.  For beginner investors, investing in ETF's is the way to go.

I haven't done a pros and cons list in a while, so here's one for ETF's.  Just because.

Some of the pros of an ETF:

  • Traded on the market- so you can short, buy on margin, or do whatever you like as you would an individual stock
  • It's also liquid- you can buy and sell as many times as you like in one day (the pricing of a mutual fund is only done once at the end of the day)
  • lower expense ratio (as little as 0.07% to 0.50%)
  • You get instant diversication without having to buy a gazillion dollars worth of different stocks
  • You can purchase however many shares you like (even just one share, if you want- though that's not really a good idea)
  • It's tax efficient (because the highly paid mutual fund manager is actively buying and selling stocks left-right-and-centre; it triggers capital gains. With ETF's there's lower capital gains than a mutual fund because you don't have that active management, hence it being more tax efficient)
  • You can see how it's doing instantly- what you see is what you get (not like a mutual fund where you would have to contact your bank/investment adviser or log-in to your account)

Some of the cons of ETF's:

  • If your brokerage has high trading commissions (e.g. $29) it may hinder you from regularly purchasing shares (aka dollar cost averaging)
  • The above con means that usually you would need much more cashola (think: lump sum) to buy ETF's than a mutual fund (e.g. you can contribute to a mutual fund $200 a month, whereas, you would likely buy $10,000 worth of an ETF at one time)
  • When you get paid out in dividends, it isn't automatically re-invested for  you (you'll manually have to compound interest it yourself/ buy more shares with the distribution)

Okay, so now what?

As you can see, ETF's are pretty awesome and snazzy.  More pros than cons.  You just have to watch out for the trading commissions and the issue with the DRIPs (dividend reinvestment).

But wait.. there's a solution. You CAN have your pie and eat it too. One of my fantastic youngandthrifty.ca's readers wrote in about Claymore funds and told me they are as good as the TD e-series.  I was like.. “whhhhaaaaa??? how can anything be beter than TD e-series?” So I did some research myself.  Claymore ETFs announced that since early 2009, any distribution paid on a Claymore ETF automatically gets re-invested!  If you want to opt out (and not sure why you would, but I guess they want to give you a choice), you just contact Claymore.

AND it doesn't stop there…Claymore also has a Pre-Authorized Cash Contribution Plan (PACC) which basically doesn't charge you any trading commissions.  You just have to buy at least $50 for each unit class each time you make the automatic contribution.

So they act like the best of ETF's and the best of mutual funds.  The best of both worlds!  The details are here.

I got stocked up on some claymore ETFs myself (CPD.TO and CYH.TO- Their management fee is 0.45% and 0.65% and the dividend payout is around 4.8%…can you say dividend ka-ching?).  Does anyone else know of any stellar ETF companies that offer the above two wonderful features?  I know that a lot of ETF companies are getting on board with the DRIPs, but I haven't heard of any other companies with the pre-authorized contribution plan.

Readers, do you hold ETFs?  Do you have the same love affair as I do with them?  Any other reasons why you like them (or not)?

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Young is a writer and former owner of Young and Thrifty and the main "twitter' behind Young and Thrifty's twitter account. She lives in Vancouver, BC and enjoys long walks on the beach, spending time with her anxious dog, and finding good deals. If you like what you read, consider signing up for email updates.

8 Comments

  1. Financial Samurai on June 14, 2010 at 10:42 pm

    Ahhh the joys of ETFs and double and triple leveraged ETFs to boot! Love em! So addicting that I just stay away 🙂



  2. young on June 14, 2010 at 10:50 pm

    @Financial Samurai- Ooh people CAN have too much of a good thing, huh? =)



  3. jill on June 15, 2010 at 10:53 am

    hi young and thrifty,
    love your site. how would one go about buying these claymore etfs? through a brokerage like questrade? how do i start on this road to dividend heaven?



  4. money reasons on June 15, 2010 at 6:43 pm

    Interestingly, I have just 1 ETF, and it’s FXI.

    It has flatlined (after dropping 20%) for the past few years, but now it’s slowly starting to show signs of life again. I didn’t have much in it so I wasn’t sweating too much 🙂

    Sounds like you got some sweet ones! Very nice dividends…



  5. young on June 15, 2010 at 6:52 pm

    @Jill- glad you love youngandthrifty.ca! Gives me fuel to keep on blogging =) LOL love your attitude- dividend heaven sounds amazing. I hope to be there when I retire- just living off my dividend payments. That would be sweeet.

    Yes, if you want to buy ETF’s you need to be with a brokerage, because they are traded like stocks. Most banks have brokerages associated with them- CIBC, HSBC, BMO Investorline, TD waterhouse, RBC Direct and there are some private ones not associated with banks, like Questrade and Qtrade. The Globe and Mail does an annual online brokerage ranking. Money Sense magazine has a great article about Couch Potato ETFs (Couch potato means you just sit back, relax, and let dividend heaven come to you, and just rebalance annually).



  6. young on June 15, 2010 at 6:54 pm

    @money reasons- FXI- that’s the iShares China fund? Yeah, I am going to include some ‘baseline’ ETF’s in my portfolio now- something steady to inject some cash in regularly.



  7. Financial Cents on June 16, 2010 at 5:18 pm

    Hey Y&T – yes, I LOVE ETFs. I used to be in high-priced mutual funds, but over the last year, we’ve slowly converted all our high-fee funds to ETFs; mostly iShares. XIU and XBB are a couple of my favourties. Nice distributions, market returns and low fees = way to my heart.

    Both ETFs are in synthetic DRIPs in both of our RRSPs. Go ETFs Go!

    Good job on the post!



  8. young on June 16, 2010 at 8:36 pm

    @Financial Cents- Nice- your financial adviser must have been pissed? (If they were getting the commissions from the high MER mutual funds). Yeah, there’s really nothing to NOT like about ETFs.. ESPECIALLY when the distributions are tax sheltered (thanks RRSP and TFSA!)



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