Exchange-traded funds (ETFs) came into existence in the 1990s in response to the high fees of the mutual fund industry. They provide broad diversification and are traded like stocks.
The original premise of ETFs is because the vast majority of mutual fund managers fail to outperform the market, it’s best to simply invest in the whole market. The intent was to hold the ETF for a long period of time in what became known as “passive” investing, rather than “actively” investing in individual stocks.
There are three main U.S.-based indexes, each having numerous ETF tracking funds. The Dow Jones Industrial Average of 30 selected, very large companies can be held through an ETF with the ticker DIA. The broader based S&P 500 encompasses the 500 largest companies and can be purchased through an ETF with the ticker SPY. The technology-based Nasdaq index can be held through an ETF with the ticker QQQ. The entire Canadian TSX can be held through an ETF, ticker XIC. International exposure can be attained through an ETF, ticker EFA, representing the developed markets of Europe, Asia and the Far East.
ETFs generally have fees ranging from 0.1 to 0.5 per cent, much lower than mutual fund fees from 1.5 to 2.0 per cent. Mutual funds, however, come with financial advisors that are paid out of the fees, whereas ETFs are generally held through self-managed accounts at internet brokerages.
Money held in mutual funds still dwarfs the rapidly growing ETF industry. Their success has led to excessive proliferation complicating what was originally designed as a simple instrument. Like mutual funds, there are now as many ETFs available as actual company stocks. There are currency-hedged ETFs, dividend ETFs, ETFs for every country in the world, ETFs for every niche sector, leveraged ETFs, ETFs that go up when the market goes down and, and, and!
Another unfortunate aspect is that while ETFs were designed to be passive instruments, they are actively traded, bought and sold in attempts to time the market, contradicting their original intent. SPY is held on average just five days. While it is too early for a full post-mortem on the recent market collapse, there are indications that younger ETF investors experiencing their first gnarly bear rapidly sold ETFs. However, there is also data showing dramatic mutual fund redemptions.
Investing in ETFs
There is an argument to be made that new investors should start with ETFs before venturing into individual stock ownership, especially if funds are limited. My suggestion would be to follow the original intent of the instrument. Buy broad indexes like SPY, XIC and EFA, holding for long periods through thick and thin, adding regularly while ignoring market dynamics to build your asset base.
ETFs weren’t yet invented when I started investing in stocks. When I moved my RRSP into a stock account in 1993, I started with half mutual funds and half stocks. The stock selections did so much better than the mutual funds, I moved solely into stocks. I now use some ETFs.
Canada, the United States and United Kingdom have a large selection of stocks, and are the only countries where I buy stocks directly. Further international diversification is derived through ETFs like EFA and EEM for Emerging Markets. I use precious metal ETFs, as described in a previous column, for sector exposure without individual security risk.
Similarly, I recently purchased a marijuana ETF, ticker HMMJ. The sector was highly speculative but as bankruptcies start to occur I think a viable industry will emerge. It is very difficult for an outsider to know which companies are solvent but I don’t think the entire sector will implode. You might recall using Tilray as an example in the article, “Investing in Speculations: An Oxymoron.” It is now six bucks versus $120 when I wrote the article. HMMJ is about 80 per cent below its speculative peak.
Canadian oil ETFs, such as XEG could also be used to invest in a very depressed industry where bankruptcies will occur, without taking individual security risk.
I enjoy the challenge of selecting specific companies and learning how all the pieces of an economy work. If more people would invest directly into companies the word “profit” would be much better understood and less vilified by society. I will stay largely invested in individual companies but recognize how ETFs can be a viable investment strategy, either solely or as a supplement to individual stock ownership.