Introduction to ETFs
In the last lesson, Mutual Funds 101, we covered how mutual funds are the result of a group of investors putting their money together into a common fund. These shared funds are then used to purchase a basket of stocks (or other assets), providing each investor with proportional ownership. The benefit is diversification (i.e. not having all your eggs in one basket).
..which brings me to ETFs.
ETFs are a like a first cousin to mutual funds, but nicer and with better wine.
By far, the most significant similarity is diversification. I realize I seem to mention diversification every second paragraph, but the concept is that critical to investing success.
Like mutual funds, ETFs—Exchange Traded Funds—are also made up of a diverse collection of assets. For example, a basket of 1000 mortgages would be a Mortgaged Backed Security ETF. (Yes, you can buy other people’s mortgages—why you would do this, we will save for another lesson.)
The underlying assets in any ETF could be equities, bonds, commodities, mortgages, etc. For the sake of simplicity, the takeaway for today is that ETFs are an excellent choice for building a diversified investment portfolio.
While a mutual fund is purchased directly from a bank, insurance company or mutual fund representative, you buy an ETF like a stock, from the stock market.
Don’t freak out!
Let’s unpack this a bit:
If we were to create an ETF comprised of the top five cosmetic companies in Canada, the rough steps would be as follows:
First, a computer program/algorithm will determine the top five cosmetic firms in Canada. (In the below example, the criteria given to the computer seems to have been “based on revenue derived from Nanci Murdock in the last six months.”)
- MAC Cosmetics
- MAKE UP FOR EVER
- The Balm Cosmetics
- Giorgio Armani
A bit of a back story: Each company that trades on a stock exchange has what we call a ticker. For example, TD Bank trades on the Toronto Stock Exchange (TSE) under the ticker: TD-T; Bell Canada trades on the TSE under the ticker BCE-T. Any given ticker will be between 2-5 letters depending on the exchange where the stock trades. Cool? Let’s move on.
Second, the investment company building this ETF would purchase the stocks of all five of the above firms. And then create a single security (with one ticker symbol) available for purchase on the TSE. This new ticker symbol represents an index of the combined value of the five companies.
Third. You purchase the ETF, by entering a buy order for ticker symbol MUP-T (also known as the Canadian MakeUp Leaders Index ETF) on the Toronto Stock Exchange. Taking this action, you pay one commission for access to the performance of five stocks. And this is the magic of buying an ETF: enjoying the performance (good or bad!) of hundreds or thousands of stocks, with just a single commission.
Ready for some math?
Assume the following:
- You purchase MUP-T for $100 on January 1, 2015
- MUP-T includes an equal amount of each of our five cosmetic companies (i.e. 20% of the performance of each company contributes to the value of MUP-T)
- On December 31, 2015, our firms had the following returns:
- MAC Cosmetics: 10% gain
- MAKE UP FOR EVER: 5% gain
- The Balm Cosmetics: 20% gain
- Sephora: (20% loss)
- Georgia Armani: (5% loss)
I am sure you can see that I made the above example super easy. Since each company has an equal contribution to the value of the ETF, the +25%, and the -25% cancel each other out, leaving the total return for the five stocks at 10%.
Remember MUP-T is an ETF that trades on the stock exchange where the price is set by buyers and sellers continuously throughout the trading day. There are a few factors that contribute to the price of an ETF. However, all things being equal, you could expect that you could sell your MUP-T for $110 – a 10% gain over the price you paid one year earlier.
OK, math over!
A clear difference between a mutual fund and an ETF is that (in general) mutual funds have active management, and ETFs have passive management. Remember Jane Smith from our mutual funds examples? Who with her team, built the XYZ Canadian Stock Mutual Fund? As the Portfolio Manager, she actively chose the stocks purchased for the fund.
Therefore, the performance of the fund—good or bad—is directly influenced by Jane’s ability to pick stocks. Right?
Conversely, in our MUP-T example, a computer – given a strict set of criteria, auto-generated the stocks we purchased for our ETF.
Sample criteria could be:
- Top 300 companies based on revenue in the last 12 months
- 50 companies who are drilling in the Alberta Oil Sands
- 100 technology companies whose revenues more than tripled last Quarter
…and the list is endless.
The above explains the benefits of passive investing: once the parameters are set, there is no human interaction in the choice of stock selection.
Important note: MUP-T is not a real ETF. (Although, perhaps it should be?) My point is there are hundreds of ETFs available on the TSE. And that these ETFs can provide you with incredible diversification (yes, yes, there is the “D-word” again..), at a very low cost. The investing landscape is virtually unrecognizable since the days an investor could purchase only single stocks, and has to pay hundreds of dollars in commission for the privilege to do so. Yes, investing was once so prohibitively expensive that only the very wealthy could afford to create diversified portfolios. But not anymore.
Please continue with the five remaining modules in this course, and I am confident the concepts will all start to make sense and you will be excited to take control of your investing future.
Watch for Lesson #4, The Dreaded MER, in your inbox in a few days!
P.S. Throughout these 8+ lessons, I may introduce terms or concepts you aren’t familiar with (yet!). Please don’t worry or think too much about it, schools are infamous for not teaching investing as a subject. I will do my best to cover as much as I can in this email series, and if you are still looking for more information, I can show you where to find it. Promise!
The Fine Print:
Investing Bootcamp is provided as an educational resource and should not be construed as individualized investment advice, nor as a recommendation to buy or sell specific securities. The investments and scenarios discussed in the course are examples only and may not be appropriate for your individual circumstances.
The investing strategies presented in Investing Bootcamp will result in losses during any period of decline in the broad stock and bond markets. All investments carry the risk of loss. It is the responsibility of individuals to do their own due diligence before investing in any index fund or ETF mentioned in this course.