If you’ve spent any time looking into new investment opportunities, it’s likely you’ve heard of Exchange-Traded Funds (ETFs). Demand for ETFs in Canada has been rising rapidly year after year, and more Canadians are asking how they can use this investment vehicle in their own portfolios. [1]
ETFs are not just for institutional investors. Passive investors can invest in ETFs like our Scotia Index Tracker ETFs designed to track indices, giving them a long-term investment option that they do not have to worry about day-to-day. ETFs also offer low costs and tax efficiencies, making them a competitive alternative to mutual funds.
Choosing an ETF in Canada starts with narrowing down your options. There are hundreds of ETFs available in Canada, and there are always new funds being created. [2] Finding the right investment for you means matching your goals, timelines and investment preferences with the funds available.
How to choose an ETF
Given the many options you have to invest in, an ETF screener can help you choose an ETF that fits your investment goals and preferences. The Scotia iTRADE direct investing platform has an ETF screener that allows investors to sort options by category, sector or country-based criteria, with advanced options for screening by volatility, ratings, risk and performance data. A screener is a useful tool for choosing the right ETF, but first investors will want to determine what criteria they want to use to evaluate their options.
Determine the focus of your investment
Decide what asset class or market you want your investment to focus on. ETFs can be built around equities, bonds or commodities and track a particular industry or index. Examples include bond indices, large-cap or small-cap equity indices, international equity indices, or indices for sustainable investing. There are also ETFs that focus on a particular investing style, such as value investing, growth or market capitalization. [3]
Narrow down your selection
Once you’ve determined the focus of your investment, you can use a screener to narrow your options from the universe of ETFs. A screener will show you the options that focus on the asset classes or investment styles you want to focus on, and from there, you can begin to compare ETFs on their other criteria.
Diversification
ETFs are an easy and low-cost way to add diversification to your portfolio because of their underlying assets. [4] If the fund’s aim is to track an index, it owns shares in companies across that index. However, an index itself can be narrow in scope if it’s limited to a niche industry or geography.
Investors who want to add diversification to their portfolio may be better served by an ETF based on a broad index with a larger following.
Evaluate each ETF
Once you’ve narrowed down your options according to asset class and investment preferences, you can compare ETFs based on objective criteria such as cost, size, performance, etc. These criteria can help show the differences between ETFs that are otherwise similar in scope and focus.
Select your ETF and place your trade
Exchange-Traded Funds are bought and sold on an exchange in the same way stocks are. Once you’ve chosen the ETF you want to invest in, you can buy it through an online investing platform or a broker.
You can now find commission-free Scotia Exchange Traded Funds on Scotia iTRADE. Investing in zero-commission ETFs can help you reduce and control your costs.
How to compare ETFs
Exposure
Investing in an ETF is often about gaining exposure to a set of assets in a specific sector, country or asset class. Indices themselves track the price performance of a group of assets, such as stocks or bonds. [5] Before you buy an ETF, you can look into its underlying assets to make sure it gives you the exposure to the companies or assets that you’re interested in.
Tracking error
The fund manager of an ETF aims to accurately replicate the index’s performance through the balance of the assets the fund owns. Tracking error is the ETF’s deviation from the original index, which can be caused by the expense ratio of the fund diminishing returns. [6]
Trading volume
An ETF’s trading activity may be a factor in its liquidity, although the liquidity of its underlying assets may be a more important factor. [7] ETFs with higher trading volumes may be easier to sell, leading to a narrower bid-ask spread (the difference between the price a buyer is willing to pay and the price at which a seller is willing to sell). [8] ETFs that trade very little may have a wider bid-ask spread, which can be an important consideration when you want to sell your position in the fund.
Current market position
ETFs that enter a sector first or earlier than the competition often have a better chance of acquiring a greater share of assets on an index. [9] Similar ETFs that entered the market later may not have the same market position as more established funds and may have a harder time adding to its assets under management.
Trading costs
Trading costs include the commission charged by the brokerage or platform when you conduct a transaction on an exchange. Commissions differ depending on the brokerage or platform you use rather than the ETF itself.
Management Expense Ratio (MER)
ETFs charge operating and management costs to investors in the fund. These management costs are disclosed as a percentage of the money invested in the fund, called the management expense ratio (MER). [10] Comparing MERs can help potential investors identify costlier ETFs. MERs may be lower in many ETFs than mutual funds because many passive ETFs have lower research costs than actively-managed mutual funds. [11]
Size & age of fund
The size and age of the fund can be important criteria. Older funds will have a longer track record, and it will be easier to evaluate their past performance. Past performance is not a guarantee of future performance, but it can help you compare ETFs to one another. Fund size is measured in assets under management.
Sustainability
Investors are increasingly looking for funds that prioritize sustainable companies. Sustainable or ESG investing balances traditional criteria with environmental, social and governance-related criteria. [12] Sustainable ETFs make it easy to incorporate ESG investing into your portfolio, and you have a wide range of options. Funds can focus on certain themes, such as filtering out controversial industries or investing in companies that champion environmental or social causes.
Provider
The rapid growth of ETFs has resulted in a large number of ETF providers, but a handful of providers are responsible for the largest and most popular ETFs. [13] The size, experience and track record of the provider should factor into your decision before investing in an ETF.
Liquidity
There are two contributing factors to an ETF’s liquidity: the fund’s average daily trading volume and the liquidity of its underlying assets. [14] Higher daily trading volume and more assets under management are usually seen as qualities that indicate more liquidity. Better liquidity can protect your investment when you want to sell your shares in an ETF, as ETFs with better liquidity often have tighter bid-ask spreads.
The type of assets under management can also affect a fund’s liquidity. An ETF that owns equities listed on a major index like the S&P 500 will have a bigger market than ETFs that focus on niche categories.
How to choose the right ETF for you
There is no one-size-fits-all solution when it comes to making investment decisions. The right ETF will depend on your experience as an investor, the costs of investing in the fund, the timeline of your investment and your long-term goals.
Experience
Beginner investors can benefit from the relative simplicity and low costs of an Exchange-Traded Fund, while more experienced investors can benefit from more complex options such as niche markets, leveraged ETFs, inverse and short ETFs and other more advanced types of funds.
Volume
ETFs are often used as long-term investments similar to mutual funds. Investors can quickly buy into an entire market and don’t need to worry about making frequent trades. The trading costs of ETFs can also mean that leaving them alone is more efficient. However, there are also ETFs that are designed for day trading and more active attention from investors.
Costs
The cost of ownership and transaction costs are both factors that play into choosing the right ETF. Investors who plan on being more active may want to focus on transaction costs, while those who are content to leave their savings alone may put a higher priority on management expenses.
Timeline
The length of time you plan on keeping your money invested in the fund can change your tolerance for risk, whether you want to lower transaction costs vs. management fees and the type of assets you want an ETF to include.
End goal
You can narrow down your investing options when you align them with your end goals. For example, if you’re looking for an investment that provides a regular income stream, a dividend ETF might be a better fit than an ETF geared toward long-term growth.
When you’re choosing an ETF, make an investment plan that defines your goals, preferences and strategy. Once you know your own investment goals, you can focus on funds that will help you achieve them.
References
[2] Canadians flock to ETFs as ETFs morph into mutual funds.
[4] Exchange Traded Funds (ETFs).
[5] Investing Basics: What Is A Market Index?
[8] Understanding ETF bid-ask spreads.
[10] A High Expense Ratio Can Eat Up Your Investing Profits. Here’s a Good Rule of Thumb to Follow
[11] How to Pick the Best ETF.