ETFs explained: What is an ETF (Exchange-Traded Fund) and how does it work?

ETFs and mutual funds both present a diversified basket of assets. Both may also be designed to follow the performance of an index or specific sector. Mutual funds are more often actively managed and come with higher management fees, although this is not always the case.

One important difference is how freely they can be traded. An ETF can be traded throughout the trading day, whereas a mutual fund can only be traded once per day at the close of the market. Investors can react faster with an ETF and have more flexibility, such as shorting or buying on margin.

Stocks provide equity in a company, whereas with an ETF there is a layer of separation in that the fund itself owns the stock. Stock values are affected by many factors, including the company’s financial performance and structure. Because they’re based on a single company’s performance, owning stocks directly can come with significant risk. A company’s value can move against broader sector or market trends, declining when the market as a whole is growing or vice versa.

One of the benefits of an Exchange-Traded Fund is that they are professionally pooled and managed and may be designed to follow the broader ups and downs of an index or industry. By pooling a basket of assets, ETFs are a more diversified investment than a single stock.

Commodities are raw materials like gold, copper, crude oil, lumber, livestock and agricultural products. They can play an important role in diversifying a portfolio, but taking direct ownership is often not an option.

Commodity ETFs may pool a combination of a physical stockpile of the commodity, stocks in companies that produce and trade the commodity and futures contracts. Holding shares in a commodity ETF opens up investment opportunities that may otherwise be inaccessible to everyday investors.

Market ETFs (or index ETFs) are designed to track the performance of a particular exchange, such as the S&P 500, NASDAQ or, for investors looking to invest in Canadian companies, the S&P/TSX Composite Index. The performance of a single company can be unpredictable and risky, and some investors prefer to track the performance of markets as a whole.

Investors looking to track the performance of an index can find out what is available with Scotia Index Tracker ETFs, including different funds’ management fees, risk ratings and distribution frequency.

These target a style of investing or asset class. They might focus on small-cap, medium-cap or large-cap stocks, focus on value or growth indexes or combine these approaches.

Bond Exchange-Traded Funds expose a portfolio to a variety of bond markets, including domestic, foreign and corporate markets. Unlike buying the bonds directly, bond ETFs don’t have a maturity date, giving investors more flexibility.

Bonds are debt instruments issued by governments or corporations and pay the buyer interest. A bond ETF can be used to generate regular cash for retirement income.

Investors who feel strongly about a particular sector’s outlook may want to focus their investments on a basket of stocks limited to one industry, such as technology, energy, pharmaceuticals or finance. These can be useful to investors who want to target sectors that historically perform well under different economic conditions.

Investing in foreign markets is another way to diversify a portfolio. International ETFs provide a relatively simple way to track major indexes around the world. A significant amount of international investing done by Canadians goes into U.S. stocks, but they also look to other foreign markets for growth. 

One important difference in how an ETF works compared to a mutual fund is that an ETF can be structured to benefit from a declining market. This is an inverse Exchange-Traded Fund, which relies on short-selling a stock using derivatives when a decline in value is expected, followed by repurchasing the stock at a lower price. Inverse ETFs open up the investment options available to most everyday investors, though they still come with some of the same risks as short-selling. 

The goal of a leveraged ETF is to return multiples on the return of the underlying investments that the fund owns. They use derivatives including futures contracts and options to leverage their daily returns. 

Many Exchange-Traded Funds are passive in that they are designed to track rather than surpass the performance of a broader market. The goal of an actively managed ETF is to beat an index through active management, which makes it closer to a mutual fund in terms of how often assets are traded.

With a currency Exchange-Traded Fund, your investment tracks the performance of a foreign currency without having to complete those transactions yourself. Some may even track a basket of foreign currencies. It’s similar to how a market ETF would track an index. 

Responsible investing or ESG (Environmental, Social and Governance) investing applies non-financial factors to investing decisions. It applies a company’s performance on environmental, social and governance issues before including it in a fund. Scotia Responsible Investing ETFs offer investors options for funds that take social and environmental impacts into account.