A FEW WORDS ON ETFS
A few years ago, at age 42, I started gardening. I know, a bit of a late bloomer (pun intended!). I read a few blogs, bought a few plants, something called Miracle Gro, a big shovel and a small shovel. And then I started digging. After two full days, I stood back and admired my work. Not only was my garden going to robust and beautiful, but in doing it all myself, I had saved a ton of money.
I was quite proud of myself. Maybe even a little bit smug.
But as the weeks past, very little turned out as I had expected. Some of the plants died. Others grew so well, they began to crowd each other and my hosta beds began to resemble some sort of home-and-garden Game of Thrones episode. The squirrels used my echinacea flowers as their own personal salad buffet and all the blooms fell off the hibiscus. I read more blogs. Was I overwatering or under-watering? If the label said, “part shade”, how much sun was enough sun?
And why did my neighbours garden look so much better than mine?!
WHY AM I TELLING YOU THIS?
Because while I was digging and sweating, and pulling and patting, watering, and shaking Miracle Gro—bursting with hopes and dreams and expectations—I failed to recognize two important facts:
- I did not have a plan, and;
- I didn’t know what I didn’t know
This is important because now I am going to tell you about ETFs. And ETFs are pretty cool. But first I need to step back and talk about diversification.
Diversification is the idea of not putting all of your eggs in one basket, or in the case of investing, consider the following examples:
- 1000 stocks instead of one stock
- ten countries instead of one country
- bonds and stocks instead of just stocks
- stocks and bonds instead of just bonds
- micro/small/medium/large company stocks, instead of just big companies
Er, if we only have $1000 to invest, how do we buy 1000 stocks, ten countries, bonds and stocks and the stocks of virtually every size of company?!
Well, there are two ways to do this:
- mutual funds
- exchange traded funds (ETFs)
First, both offer exceptional opportunities to diversify your portfolio. If you are looking for asset allocation (cash, bonds, stocks, Real Estate, Commodities) you will be well served by both mutual funds and/or ETFs.
That said, there are two fundamental differences between mutual funds and ETFs: active management vs. passive management, and fee structure.
ACTIVE vs. PASSIVE
In the decades before the computer (yes, I can remember…) if a mutual fund had the mandate to hold 1000 stocks, a Portfolio Manager, and his or her team would have to research the Universe of available stocks and choose the individual 1000 stocks for the portfolio. This strategy—inclusive of human decision-making—is called active management. And for years, it was the only game in town.
Fast forward to 2016, and we are now in the midst of a technological shift that is disrupting virtually every industry that touches our daily lives. The investment industry is no exception: the last decade has ushered in with it the rise and proliferation of low-cost and easy index investing—dramatically altering the investment landscape.
What is an index?
You know how when Global TV says, “78% of Canadians think Justin Trudeau is doing a good job,”? We understand that the polling company did not call every Canadian. We accept that they called a segment or cross section of Canadians and that this cross-section of Canadians can be considered a proxy for most Canadians. And so it is the same with stocks (or bonds). An index is a certain number of stocks or bonds that serve as a proxy for the entire market you want to own. And that index is chosen (probably in milliseconds) by a computer. This investing, by an algorithm, is called passive investing.
In general, mutual funds in Canada have an embedded fee structure. Meaning that your fees, which are a percentage based on the total amount of assets you have invested with your Advisor or fund company (i.e. $80.000), are taken by the fund company before your annual returns are reported to you. This annual fee is called the Management Expense Ratio or MER, and it used to pay the operating, sales and marketing, and trading costs of the mutual fund. It is also possible that a portion of the MER is paid to your Advisor as compensation for both financial and investing planning you receive. MERs vary between fund companies and asset classes (i.e. bond funds will have a lower MER than equity funds), but MERs between 1.5% and 2.5% are relatively standard.
The annual fees for ETFs. Because the computer is selecting the investments in the fund (it is still called a fund, just exchange traded fund instead of mutual fund) and because there is no advice given (and I mean none), you will often see annual MERs for ETFs well under .5%.
Also, it is important to note that while you can easily purchase mutual funds through your bank or an Advisor, ETFs trade like stocks and must be purchased through a self-directed brokerage account. Which means, yes, more time, work and responsibility done by you as a DIY investor.
WHICH IS BETTER—ETFS OR MUTUAL FUNDS?
There is no one-size-fits-all or black and white answer to this question. Because ETFs offer diversification with low fees, you will often see financial media and bloggers abandon their mutual fund portfolios (and Advisors) for cheaper, leaner do-it-yourself ETF portfolios.
However, in the case of my somewhat failed landscaping project, this decision puts you at risk of finding yourself in a situation where you have no plan and don’t know what you don’t know. And when you realize you are in over your head (or up to your knees), no access to a knowledgeable professional to call and help sort it out.
If you are new to investing, I will say this: There is probably a place for ETFs in your overall plan. Maybe now, maybe later. But like any DIY project or passion, there is a significant time commitment and learning curve to become skilled. And while I confess to being one of those financial bloggers that loves to wave the ETF flag, I will say that having a rock solid plan and good advice beats cheap each and every day.
In the end, I hired a landscaper. I paid several thousand dollars to have my beds restructured and for a plan that included, you know, knowledgeable advice about which plants go where, taking sun shade and eventual size. As I learn more, I rely on my landscaper less. And although one day it is possible that one day I might do 100% of my own landscaping, I have to admit it is pretty nice to have someone else to the heavy lifting.
I have a course, Zero to Portfolio, An Investing MasterClass, launching before July 30, 2016 (in just a few weeks!). The course is structured as ten modules, delivered in pre-recorded HD video, where I walk you, step-by-step, through primary asset classes, asset allocation, diversification, ETFs, RRSPs & TFSAs, portfolio rebalancing, and much, much more.
Click here if you would like to be notified when the course is ready for purchase.
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