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Investing 101: ETFs

Exchange-Traded Funds (ETFs) have increased in popularity in the past decade because of their ability to benefit from diversification. For those of you unfamiliar with ETFs, they’re a collection of securities that trade on a stock exchange.

ETFs can be a combination of stocks, commodities or bonds and can consist of strictly domestic securities or can be international. ETFs can consist of a handful of different securities in various industries or thousands of securities in one specific industry.

All about ETFs

ETFs allow investors to diversify without the cost of buying every stock individually. The ability to diversify is a significant part of an ETF, as no other investment vehicle (except mutual funds) allow investors to benefit from the investment in hundreds of different stocks with a single investment vehicle.

ETFs have low to no commission, which means that trading an ETF is a more affordable option than mutual funds, which often come with high management and commission fees.

It can be focused on one specific industry such as banking and energy or it can be broad and cover stocks across all industries. The two main types of ETFs are actively managed ETFs and passively managed ETFs.

Actively managed ETFs make use of portfolio managers who regularly buy and sell securities of the fund to change the weighting of each security to maximize gains. This comes with a higher fee as the fund manager takes a more hands-on approach.

Passively managed ETFs can be described as a buy and hold investment strategy. Fund managers of passively managed ETFs do their due diligence before investing and periodically check the fund to ensure the investments are performing as expected.

It is widely agreed that during an economic boom, passive funds are the best choice, as returns are not diminished by the fees associated with an actively managed fund. That said, when there is an economic downturn, active fund managers are able to shield investors from specific market risks.

An example

One of the most widely held passive income funds is State Street’s SPDR S&P 500 ETF, which has a market capitalization of $260 billion. Canada’s answer to State Street’s ETF is BMO S&P TSX Capped Composite IDX ETF, which tracks the performance of the S&P/TSX Capped Composite Index and currently has $4.1 billion in assets under management. BMO’s ETF consists of small, mid and large market capitalization companies. Different market capitalizations have different risks and rates of return.

Bottom line

ETFs are a good choice for investors with minimal capital who wish to benefit from diversification. As they’re is listed on the stock exchange, investors also benefit from added liquidity, which means that it’s easy to buy and sell ETFs.

The downside to ETFs is the fact that they charge a management fee for managing the fund, which can add up over the years. As well, diversification may limit investors to capital gains, as strong industries in the fund will be offset by poorly performing ones. In a fund with hundreds of stocks, the rate of return may be much less than expected.

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Fool contributor Chen Liu has no position in any of the stocks mentioned.

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