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What are ETFs?

December 9, 2020

Written by Preet Banerjee

Key takeaways

  • Exchange-Traded Funds are a way for many investors to pool their money together and to have this money invested according to a particular strategy or philosophy.

  • Unlike mutual funds, they are traded on an exchange, just like a stock.

  • It’s easier to make automatic contributions to mutual funds, but ETFs tend to have lower fees.

What are ETFs?

ETF stands for Exchange-Traded Fund.

That might sound like an abstract term, so let me give you a rough definition: you can think of ETFs as just investment funds. And an investment fund is a way for many investors to pool their money together and to have this money invested according to a particular strategy or philosophy.

Why would an investor do this?

Well, if you don't want to spend time figuring out the best way to build and manage your own investments one by one, you can find a fund that is managed on your behalf. Another popular investment fund structure is a mutual fund. 

Differences between ETFs and mutual funds

ETFs are traded on an exchange, just like a stock. Buying or selling them is usually subject to trading commissions. To save and invest on a regular basis, you might need a two-step process: you could have money automatically contributed to your brokerage account, but you might still have to manually purchase your ETF once the money arrives.

With most mutual funds, you could easily set up a plan to automatically have $100 per month (as an example) contributed from your bank account and directly into your investment. This makes saving and investing on a regular basis much easier to do.

Mutual funds tend to be more expensive than ETFs because in Canada, mutual funds have traditionally been sold through financial advisors and mutual fund sales representatives. These "middlepersons" come with extra costs, such as salaries and commissions, that are often built into the ongoing costs of mutual funds, in part because of the advice they offer. 

Another reason mutual funds tend to be more expensive than ETFs is because many mutual funds are actively managed whereas many ETFs are passively managed. Active management tends to be more expensive than passive management.

How do ETFs compare with mutual funds?

There's probably more in common between the two than there are differences. Think about the one common word in both terms: Fund.

Both ETFs and mutual funds are "investment funds." As described above, a "fund" allows many people to pool their money together and to have this pool of money invested on their behalf. 

It's important to note that many people equate ETFs with passive investment management (or index investing), but ETFs can be actively managed as well.

Conversely, many people equate mutual funds with actively managed investment funds. And again, while many of the biggest and most popular mutual funds are indeed actively managed, there are many passively managed mutual funds as well. Either structure, an ETF or a mutual fund, can be either passively managed or actively managed.

Holding ETFs in a mutual fund structure

It's possible to use a mutual fund structure to hold a series of ETFs, and this could be advantageous, since it allows an investor to access a potential lower cost portfolio that has exposure to ETFs while still having some of the conveniences of a mutual fund structure (namely, the ease of setting up a regular contribution plan to a mutual fund versus placing trades to buy ETFs on an exchange). 

Remember, whether you decide on ETFs, mutual funds, or a combination of both, it's always important to make sure your financial goals and investment objectives are considered in order to ensure your investment choices are the most suitable for you.

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