What is an ETF? Our Portfolio Manager explains
Read insights from Neville Joanes, portfolio manager, about how ETF’s work and why they are so popular.
In layman’s terms, what is an ETF?
As you might know, stocks are units in a company that are bought and sold on an exchange – if you want shares in Apple, you can buy shares in Apple.
An ETF performs the same as a company, like Apple, on the stock exchange, except it is not a company, it is a overarching fund that holds shares from many companies.
Right, so what does that look like?
An ETF can hold shares in a broad spectrum of companies, or choose to curate specific stocks to make a narrow ETF. Think of it like an art collector who is a fan of the surrealist era. The collector curates a collection of works by Picasso and Dali to exhibit at a gallery. The ETF is the gallery and the chosen stocks are the paintings.
For example, the BMO Equal Weighted REIT ETF is a narrow ETF with shares from a handful of Canadian Real Estate Investment Trusts. Alternatively, the S&P 500 Core ETF holds shares in equity assets in industries like healthcare, technology, financial services, and more. This type of ETF is more like an art museum that collects all types of art.
From the investor’s perspective, when you buy a share of the ETF, you get a small part of each of the stocks in the ETF.
So, going back to the art analogy, if you buy into the collection, you get a piece of each painting.
Yeah, but you don’t want to do that to art.
OK. So why should investors be looking into ETFs?
One of the major advantages of purchasing an ETF share is diversity. Having a diverse portfolio is important to some investors because if one stock performs poorly, another one might perform well, counterbalancing the loss.
So, if you have a tech based ETF that includes Apple and Apple stocks decrease by five per cent, but the rest of the stocks swing upward, than the impact of the Apple stock will have less effect on the entirety of the ETF.
Using the painting analogy. If the Picasso in your collection suddenly loses value, but the Frida Kahlo increases in value, your overall collection doesn’t suffer to the same degree as it would if your collection was only Picasso’s.
You’d be in trouble then.
Most ETFs are passive, which means they essentially track the market. There isn’t a middle man – called an active manager – trying to come up with creative ways to beat the market. This along with how they operate makes them more efficient and less costly than, for example, a mutual fund. The market does well, the ETF does well. Simple. Furthermore, only a small percentage of active managers consistently outperform the market, so going with an ETF makes sense for most investors.
Sounds pretty sound.
There are risks with an ETF, just like another other stock or mutual fund. You’re not guaranteed to make money, but what it will give you is access to a broad spectrum of the market.