Picking individual stocks to trade is incredibly risky. Trying to predict a single company is a gamble: stocks can increase or decrease in value. Predicting a collection of companies or sectors on the other hand is relatively easier. The difference is between:
- Will Tesla’s stock price go up in the next 10 years?
- Will EVs be the future of transportation in the next 10 years?
Both questions involve Tesla’s stock price but the second one’s more general than the first. It also doesn’t specify that TSLA will even be the big EV winner in the long term. By investing in the second notion, you are far more likely to be right than the first. ETFs allow you to do invest in exactly that.
A good investor always looks to reduce risk. ETFs allow you to instantly diversify your risks at a much lower commissions cost than buying individual stocks.
What is an ETF?
An Exchange-Traded Fund (ETF) contains a collection of securities with a specific composition. It also closely follows the movements of its holdings. If APPL goes down in price, then an ETF holding AAPL can also be expected to go down.
An ETF can contain any number of stocks, bonds etc — it depends on the way it was constructed. By buying an ETF you are indirectly buying the securities that it holds in its composition. Let’s look at an example ETF below.
The EXAMPLE.ETF holds AAPL, TSLA, and SHOP. Therefore if you buy EXAMPLE.ETF you are indirectly buying parts of the said stocks.
Commissions on buying an ETF are always lower than buying individual stocks. Questrade charges $4.95 to $9.95 (depending on how many shares you buy) but trading an ETF is free.
If ETFs are free, how do they make money? Good question. The answer is the Management Expenses Ratio or MER. Companies that run and maintain the funds charge a percentage fee on the funds invested. These fees need to factored in to understand your ultimate returns. As an example, if you invested $10k in an ETF that charges 0.50% MER and it returned 0% growth for the year. Your funds will decrease by $50 to $9,950 at the end of the year.
Fortunately, most management fees are super low. In 2018, fees at U.S.-registered passive funds averaged 0.15%.
Pro Tip: You can look up the Expense Ratio and other useful fund information for any ETF here.
The Market ETF — SPY
When people talk about beating the market, they are talking about getting better returns than an ETF that tracks the S&P 500 index (Collection of US’ top 500 companies).
SPY is an example of a US ETF that trades on NYERSCA and tracks the S&P 500. In fact, you can take a look at its holdings here. SPY is the easiest way to invest in the market. Since it contains the topmost companies the country has to offer, as long as you trust their performance, SPY will continue to perform.
For Canadians: The Canadian equivalent of SPY that trades on the TSE is VFV.TO. It also tracks the US S&P500 with the added benefit that you can buy it using CAD and not USD.
- Lower commission fees than buying individual stocks.
- Instant Diversification.
- Trades like stocks.
Things to be careful of
- High MER fees.
- Less diversified ETFs; ETFs that track highly correlated securities end up increasing your risk.
- Highly Leveraged ETFs. An example, UGAZ gains/loses 3x the daily returns of the underlying Natural Gas ETN Futures. This increases the risk by 3x. Better to stay away from these.
Bottom Line: ETFs provide easy broad market exposure with low commissions; an essential part of a sound portfolio.
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