Exchange Traded Funds (ETFs) – Part I

Now that you’ve had time to read (and absorb hopefully!) all the wonderful information about mutual funds, you must be wondering what ETFs are, and why I prefer them over a portfolio of cheap index mutual funds.

What are they?

ETFs are very similar to mutual funds as they are essentially a portfolio of stocks and/or bonds. The main difference is, as the name implies, that these funds are traded on a stock exchange. So instead of going to your friendly neighbourhood bank or investment company and having them purchase mutual funds on your behalf, you will need to set up a brokerage account and actually purchase the ETFs yourself. You can set up a brokerage account at companies affiliated with the large banks (i.e. RBC Direct Investing or TD Waterhouse), or you can set up an account at a discount brokerage (i.e. ETrade or Questrade). Once your brokerage account is set up, you can then proceed to purchase and sell ETFs on the stock market.

Advantages

ETFs have similar advantages as index mutual funds do: they provide diversification, the MERs are cheaper than both normal mutual funds as well as index mutual funds, you have a fund manager to purchase all the underlying securities for you, and you can easily sell your ETFs on the stock market if needed. Another big advantage is that you can control the tax implications on your portfolio (i.e. you can only trigger capital gain or losses when you sell your ETF, therefore, effectively timing the tax implications to your advantage).

Disadvantages

Transaction costs – as every ETF is traded like a stock on the stock exchange, there is a transaction cost every time you buy or sell. Depending on the size of your portfolio, this may end up being an advantage, but you will have to remember to take into account both transaction costs as well as MERs when determining the cost of your portfolio.

Stock-like feature – the ability to buy and sell an ETF on the stock market is a great advantage, but it can also be a great disadvantage as well. It may become tempting to watch the movement of the price of the ETF and one may try to time the market to lock in gains. This will result in increased transaction costs as well as adding complexity into the equation. Remember, we want the easiest, most cost effective way to save and grow our money. We do not want to add in temptation to sabotage ourselves!

As long as you stick to broad-based market index ETFs, you should be able to replicate index mutual funds at a fraction of the cost. If you are just starting to invest and do not have a large sum of money, or if you are intimidated by the thought of having to purchase ETFs on the stock market, you may want to stick to the e-series index mutual funds for the time being. Once your investment portfolio grows to around $50K, it may be worth looking into replacing the index mutual funds with ETFs as the MERs are much lower and you will have a lot more control over your portfolio.

In Part II, I will go over how you can set up diversified and well-balanced portfolio using ETFs.

What do you think? Are ETFs something you are considering adding to your portfolio?

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