If you’re reading this, you’ve probably heard about ETFs before, but you’re not sure if you should be investing in them, or which ones to invest in. So, let’s break it down.
What Are ETFs?
ETF stands for Exchange Traded Fund – basically, they’re funds that are traded on the stock exchange (hence the name).
Let’s start with the ‘fund’ part. A fund is a basket full of different types of investments, like a stock or a bond, all bundled up and put together for you. Not only can funds be diversified by having different types of investments, like stocks or bonds, but you can also buy funds focused on different types of industries, company sizes, or countries.
For example, there are ‘tech funds’, ‘US company funds’, and ‘large company funds’ – or, you can get more specific with a ‘large US tech company fund’.
Overall, a fund is a basket of different types of investments that you can buy altogether, and you get to choose specifically what type of basket you want to buy.
Actively Managed vs Passively Managed Funds
Now, the other way that funds are classified is by how it’s managed – there’s both actively managed and passively managed funds available.
We want to focus specifically on passively managed funds, because they’re typically lower cost and they outperform actively managed funds over 90% of the time (seriously!).
Let’s break that down – actively managed funds mean that the basket of investments is controlled by a fund manager, so a real person, that decides exactly what investments should be in, and out, of the fund over time. That’s the active piece – there’s a person actively analyzing which investments are ‘best’ with the aim of outperforming, or beating, the market. They decide what to buy, and what to sell, and at what time, to get those ‘best results’.
The thing is, fund managers don’t beat the market over the long-term 90%+ of the time. Seriously, there are countless studies that show how trying to guess what investments will perform best for decades will actually lead to lower returns almost every single time, and you also pay more money to make less money. That’s because actively managed funds have higher fees – there’s literally someone involved whose job it is to actively manage the fund – and these fees are typically around 1-2%, which can really add up and eat into your total investment return.
The good news is that passively managed funds also exist – the fees aren’t nearly as expensive and they typically perform better over the long-term – so that’s the type of fund that we want to focus on.
How Do Passively Managed Funds Work?
Funds, in general, were created to make diversified investments more accessible – they let you have access to more investment options, because it can be expensive to have to buy stocks individually, and it makes it harder to reduce your risk through diversification.
Diversification means that you’re reducing your risk by not having all of your eggs in one basket. For example, if you had all of your money invested into Apple stock – that might seem good right now, when you look at the high long-term return, but if all of a sudden the company completely crashed tomorrow, all of your money would be gone. Obviously that’s kind of risky, and one way to reduce this risk is to have a mix of multiple different stocks – or different investment options – spread out over different industries or global markets (aka investing in funds instead of individual stocks).
Now onto the next question… How do passively managed funds work?
Passively managed funds are still a basket of different investment options that you can buy altogether, but this time there isn’t a person choosing what’s going into the basket. Instead, your basket is passively managed, and the goal isn’t to beat the market, it’s to match the market. The reason that there isn’t a person picking the investments is because they don’t have to be picked at all – instead, they literally match a market index that already exists.
An index is a portion of a financial market. It’s easiest to picture this by using an example, so let’s use the S&P 500. The S&P 500 index looks at the performance of the 500 largest US companies – aka how much those companies’ stocks go up and down – altogether. You can buy a fund that tracks that exact market index, which means the fund would contain a tiny piece of all 500 of those same companies. It means that you’re guaranteed to make the exact same return that the overall 500 largest US companies will make in any given year (minus the small fee you may still be paying).
Keep in mind that there’s multiple different funds that track the S&P 500 market index – for example, there’s VOO, IVV, SPLG, and SPY. They’re all very similar – they literally track the exact same companies – but they’re offered by different companies with slightly different fees.
Then, there’s also multiple different market indexes that you could track. There’s the total US stock market, there’s US tech stocks, then there’s the Canadian total stock market… pretty much any country, or collections of countries, all over the world has an index you could track, and then there are different industry and company size breakdowns, too.
That means that there’s a lot of different funds, and specifically ETFs, to choose from.
How Do I Choose A Specific ETF?
When there are so many options, how do you figure out what ETF, or ETFs, you should actually invest in?
There are few things that you can consider in order to help you narrow this down –
- What are you investing for? Are you investing for retirement (aka the long-term)? Are you investing with the purpose of buying a house (aka short- or mid-term)?
- How old are you right now? Are you in your 20s and won’t be touching your investments for decades? Or are you in your 50s looking to start using your investments to fund your life within the next couple of years?
- Where do you live? Do you live in the United States? Do you live in Canada? Or do you live somewhere else around the world?
- Do you want to invest in a specific type of company? Large companies, the total market, technology companies…?
The first two questions specifically impact how ‘risky’ you want to be with your investment choice – basically, the longer you plan on having your money invested, the more you can handle lower returns in the short-term, as long as the long-term return is higher. If you are investing for a long period of time, then you might want to consider all equity ETFs (ETFs that only hold stocks and no bonds), but on the other hand, if you’re investing for a shorter period of time, you might want to consider ETFs that are more diversified (ETFs that hold both stocks and bonds).
Where you live also impacts the ETFs you’d pick for a few different reasons. One reason is fees – for example, if you live in Canada but want to invest in the S&P 500, you could buy VOO and pay conversion fees (because it’s listed on the New York Stock Exchange in USD), or you could buy VFV and avoid those fees (because it’s listed on the Toronto Stock Exchange in CAD). There’s also additional tax implications that come along with holding one or the other, depending on the type of investment account that you’re using.
There’s also something called Home Country Bias, which is when you have a higher portion of your money invested in companies from the country you live in than someone from another country would, simply because you live there.
It could be favourable from a tax benefit perspective to have a higher home country bias, but it could also be unfavourable if you live in a country that has more volatile or unstable financial markets.
After factoring all of those considerations, you should be able to start to narrow down your search regarding what ETF, or ETFs, you want to invest in.
Make Sure You Avoid Fund Overlap
The last thing you need to know is that you want to avoid Fund Overlap, which can happen when you invest in multiple ETFs. If you do, you want to ensure that they don’t contain positions in the same stocks.
For example, if you invest in an ETF like VOO (which tracks the S&P 500) and also VTI (which tracks the Total US Stock Market) you’re going to have exactly 500 stocks overlapping, because every company in VOO is also in VTI. This basically means that you’re double dipping, and throwing off your portfolio balance.
On the other hand, if you wanted to invest in both the Total US Stock Market and the largest stocks in Canada, you could invest in VTI and VCE without any fund overlap, because no companies are both American and Canadian at the same time.
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