WHAT IS AN ETF AND WHY DO I CARE?
For many people out there, ETF might as well stand for Extra-Terrestrial Fund. Let’s break it down so we’re all on the same page:
ETF = Exchange-Traded Fund
Exchange-Traded = something that is actively traded on an exchange, like the Toronto Stock Exchange(TSX)
Fund = when something is called a fund in the investment world, it usually means that someone with a bunch of money bought shares of a lot of different companies, and lumped all of these different shares together in something called a fund. They monitor all of the stuff in this fund and make sure that all the pieces are working together to do what they are supposed to do: make money. Usually the people who have all this money and build funds like this have a pretty good track record of making money. Because of this track record, they are able to take their fund and sell it to individual investors (like you), in small chunks. The investors own small chunks of the fund, but only the people who created the fund actually own the shares of all the companies in the fund. You might say the investors(you) own the companies indirectly. Because the investors only own one thing(the bit of the fund) and they don’t have to spend time tracking a whole bunch of companies to make sure that the fund is making money, the investors are ok to pay the people who built the fund a little bit of their return(income) for doing all of the hard work of picking and choosing.
So as you can see, the F is the most complicated part of ETF. I believe the best way to understand something is to take it apart and see how it works. I used to do this a lot with my GoBots when I was a kid (but I wouldn’t put them back together, right Mom?).
But before we dissect an ETF, it’s important to understand why ET makes an ETF a better F.
I WANT ALL THE FUNDS!…OR DO I? WHAT’S A FUND AGAIN?
The most popular types of investment funds are Mutual Funds, Index Funds, and Exchange-Traded funds. They all follow the basic definition of a fund (see above), but are slightly different:
Mutual Funds: People who think they can do better than the market(make more money) will set up a mutual fund and hire a hotshot fund manager(like Joel Tillinghast, for example) to make their investors money. Companies need a license to sell mutual funds so you can’t just go and buy them yourself at the mutual fund store. Mutual funds sometimes have sales charges(or deferred sales charges) and always have high management fees. Management fees are high, say 2.5%, because the idea is the amazing fund manager(Joel) is going to make everyone more money and so the high fees are justified.
Index Funds: They are still mutual funds but with lower fees and less management. Why? Because an index fund is meant to mimic the return of a specific index(more about indexes here). An index is already a cross-section of a stock market or an industry sector, so all of the picking and choosing and crafting has been done. The work is just making sure that the fund remains balanced. So fees are cheaper, like 1% instead of 2.5%. But you still have to buy them from specific places, like banks, or advisors with a licence to sell mutual funds.
Exchange-Traded Funds(ETFs): Still a fund, per the definition, but the fund itself is traded like a stock on the stock market. So as easily as you could go and buy 10 shares of Google from your broker, you can go and buy 10 shares of an ETF that owns a small portion of 200 companies. And today, the management fees for many ETFs are super-low, like 0.06%, for example.
WHY DO YOU CARE SO MUCH ABOUT LOW MANAGEMENT FEES?
I get it – maybe you think there isn’t a big difference between 0.12% and 2.5% in fees. All seems pretty low already. And we pay higher fees for the mutual funds because we are going to get higher returns, so it all works out for the best….right?
Not exactly. This is all wishful thinking.
You have to remember, whenever you are investing your money, that nobody can predict the future. If someone tells you: “Pay me more money, and I’ll make you more money!”, that is just an intention. There is no guarantee they can do this.
Warren Buffett is one of the most successful investors in the world. He would take money from people to invest in what he thought were the best companies, and as it turns out he made a lot of people a lot of money. But Buffett never said he would make people money, he said he would try. Here’s a quote from a 1962 letter to shareholders:
I am certainly not going to predict what general business or the stock market are going to do in the next year or two since I don’t have the faintest idea.
If Warren Buffett doesn’t have the faintest idea, then anyone who claims they do is probably lying to you.
Turns out a lot of these highly paid mutual fund managers get similar or even worse returns than the low-fee ETFs.
So keeping that in mind, let’s assume the following:
- A mutual fund and an ETF both have average annual returns of 5% for 25 years.
- You put in $100,000 in each one and just let it ride for 25 years.
- Mutual fund fee is 2.5% and the ETF fee is 0.25%.
In 25 years your mutual fund grows from $100,000 to $185,000
In 25 years your ETF grows from $100,000 to $319,000
THE FEES MADE A DIFFERENCE.
A $134,000 DIFFERENCE.
OK I’M CONVINCED – ETFS ARE GOOD, LOW FEES ARE GOOD. BUT I STILL DON’T UNDERSTAND WHAT I’M BUYING AND WHY THE FEES ARE SO LOW? IT ALL SEEMS SUPER COMPLEX.
You’re totally right. It would take a lot of time to look at every company in a typical ETF. That’s because it’s usually really diversified.
But it’s important to try to understand what we’re buying so let’s look at one ETF from iShares called XIC. XIC has 240 different Canadian companies in it. It has a 0.06% MER which is crazy low.
ETF fees are often very low because they can be managed by computers, using predetermined formulas that are created and monitored by humans, but don’t require a lot of hands-on management once they are setup. There is nothing to research or actively manage, because the concept is that they are just copies of existing buckets of stocks, bonds, real estate, etc. that already exist out there. The formulas and computers make sure the ETF follows the growth of the existing buckets, or indexes
Note: Currently 10% of the money I have with Wealthsimple is invested in XIC.
If you want to see the full list of 240 companies, you can find it here. But the important thing to understand about an ETF is how well diversified it is, in general terms. So here’s the breakdown of XIC by market sector:
|Market Sector||% of Fund in Sector|
|Financials (the big banks and insurance companies)||33%|
|Energy (oil and gas like Enbridge, Suncor, Cenovus)||20%|
|Materials (mostly mining)||13%|
|Industrials (railways, airlines, and big construction)||9%|
|Telecommunications (you guessed it - Rogers/Bell/Telus...and Manitoba Telecom!)||5.5%|
|Consumer Discretionary (mostly Magna, but also Canadian Tire, Cineplex and The Bay)||5%|
|Consumer Staples (big grocery stores and food manufacturers)||4%|
|Real Estate (companies that own and collect rent on properties)||3%|
|Information Technology (tech companies like CGI, Blackberry, Open Text)||3%|
|Utilities (big hydro like Fortis and Emera)||3%|
|Health Care (mostly Valeant Pharmaceuticals)||1%|
|Cash (always keep a little bit of cash on hand)||0.5%|
So you’ll want one like this, but one Canadian ETF is not enough to keep you balanced in the long term. What if something happens to the Canadian economy and you have all of your money in Canadian investments? Sure you may want to invest all your money locally to be patriotic, but on a global scale, that’s like investing all your money in one company, and you wouldn’t do that, right? So how about adding an international ETF, and a US one too. Maybe some real estate and a bond ETF to round things out.
BUT I DON’T HAVE THE TIME TO BUY ALL THESE ETFS MYSELF. AND I DON’T HAVE A BROKERAGE ACCOUNT. AND I HATE BROKERAGE FEES BECAUSE YOU TAUGHT ME TO HATE ALL FEES.
Yes, please keep hating brokerage fees and high fund management fees. I like that about you.
It does take a lot of time to build a diversified portfolio of ETFs on your own, and it would cost you a lot in brokerage fees to do it through a traditional brokerage, especially if you wanted to spread out your purchases over the course of a year to manage your cash flow.
I know I talk about Wealthsimple a lot, but here’s the deal: You pay them just 0.5% to buy a whole bunch of ETFs for you. You just tell them about your risk profile and then they do all the work. They keep your portfolio balanced, they move things around to make sure you’re always getting the most for your money, and they only buy low-fee ETFs.
Ok, so the extra 0.5% will cost you $36,000 in extra fees over 25 years.
How can I justify this when I keep telling you fees are bad? Maybe they’re not all bad.
GOOD FEES VS. BAD FEES
The 0.5% is not a fee for managing the funds and picking stocks, it’s the price you are paying for them to craft a portfolio for you, manage your risk, and be your broker. All the things that would take you a lot of time, money, and research to do on your own.
I decided that 0.5% is a reasonable price to pay to have someone do this for me. You may think that $36,000 over 25 years is way too much, but there is a difference between paying a fund company a fee to manage their funds and paying someone to manage your personal investment portfolio.
The fund fee is like the cost of a product, or a tax, if you will, like the tax on gas you buy at the pump. It is what it is, and you hopefully don’t have to pay that much in tax, but it doesn’t really add any value to your life.
The Wealthsimple fee is you paying them to provide a service, and to give you the time to focus on the rest of your life, like a full-serve gas bar. You pay a little bit more for the full-serve gas, but you don’t have to get out of your car in the middle of winter, and they might also check your oil and clean your windows.
Another key thing to consider is that you may not be very good at picking ETFs and balancing your portfolio. When I say that you are foregoing $36,000 over 25 years, that only holds true if you think you can get the same returns as experienced portfolio managers.
Automating your investments as much as possible is one of the primary keys to personal finance serenity. Automate your tracking/budgeting with Mint.com, and automate(but also diversify) your investments with companies like Wealthsimple, or Tangerine Index Funds or another low-cost option with which you are comfortable.
The key is to balance the fees you pay with the cost of your time. Also it is important to consider how much value focusing on investments adds to your life.
If you have the time to buy and sell ETFs on your own, but you are not going to enjoy it, then maybe 0.5% paid to someone else is worth it for you. Maybe you could do it all yourself and save $36,000 over 25 years, but even if you enjoy it, could you be spending that time with family and friends? Or on something creative to enhance your life?
But even though you may choose to have your investments taken care of by someone else for a small fee, it’s still very important for you to understand and be comfortable with what they are doing with your money.
That’s why I told you about ETFs today, so you can be a wise enough investor to understand what’s happening and then make an educated decision about whether you want to do it all yourself or delegate the time-consuming stuff to someone else.