A lot of people have heard of exchange traded funds (ETFs), but don't really understand what they are or what a great investment they can be.
ETFs are not a novel concept -- in fact, they have been around for over 20 years. Worldwide, there is currently $3.5 trillion invested in ETFs. Interestingly enough, the average household income of investors in ETFs is $131,000, more than twice the median household income and about 30 per cent higher than the average income of households that own plain mutual funds, according to the Investment Company Institute.
But what is an ETF, you say? ETFs are funds, which means that for all practical purposes, each one includes dozens, hundreds or even thousands of stocks or bonds. Most ETFs track broad, well-established indices like the S&P 500 or the TSX. Large institutional investors typically use ETFs to cheaply and efficiently gain exposure to a variety of asset classes including bonds, stocks and real estate. When compared to mutual funds, a significant difference is that ETFs usually have much lower fees and can be bought and sold throughout the day.
So, how do you pick the right ETFs? Here are the criteria I use.
Look for low costs
If you read my column regularly, you know I have a problem with the high cost of mutual funds in Canada with the average Canadian equity fund charging 2.42 per cent a year. In fact, a recent study by the Canadian Centre for Policy Alternatives published in February 2015 found that the high cost of mutual funds in Canada has a significant impact on Canadians ability to grow their wealth. Think about this: 30 per cent of your potential wealth might never be yours because of high mutual fund fees.
So, when looking at any investment, including ETFs, it's imperative that you identify the cost, or the expense ratio, before you pick it either for your retirement plan, your kids' education portfolio or your other investments.
I tend to go with blue-chip ETFs from iShares and Vanguard. On the plain vanilla funds (see below), those fees can be as low as 0.05 - 0.15 percent a year, or $5-$15 for every $10,000 invested.
Consider the investment style (plain vanilla is probably best)
When it comes to ETFs, most people would be better off sticking with passive ETFs that track broad indices, like the Russell 2000, the S&P 500, or a bond index.
It’s important to note that actively managed ETFs do exist as an option where you attempt to beat the market. However, research shows that passive, low cost investments have yielded better comparative returns over time. Be the market, don't try to beat it.
Make sure your ETF is liquid
Why does liquidity matter? If you want to sell your ETF, you want to make sure there is enough of a market in it -- enough liquidity -- so that you find a buyer when you want one.
If you stick to plain vanilla ETFs, liquidity is unlikely to be a problem. If you dabble in more esoteric ETFs, make sure there's enough liquidity.