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ABCs of ETFs – Exchange Traded Funds

Background on ETFs

Early on most investors in ETFs were institutional investors including pensions funds, hedge funds and mutual funds otherwise known as "The smart money". Today, more and more ETFs are held by individual retail investors like you and I, and for good reason.

First introduced by the TORONTO Stock Exchange, exchange traded funds were the fastest growing asset class in North America in 2007. In the early part of 2008, there were 10 new ETFs launched in the United States and 8 in Canada bringing the total number of ETFs to over 650 with assets in excess of $ 550 billion. Very impressive.

In Canada, iShares from Barclays Canada is the dominant player. When trading any security you want to make sure there is ample liquidity. The average daily volume of the TSX 60 (XIU) has almost doubled in the past year. Claymore Investments Inc. and Horizon BetaPro's leverage ETFs are gaining market share. In the US, the year over year monthly volume has more then doubled. The most active, the S & P500 (SPY) has been an amazing success story since being launched in 1993 (launched by State Street Global Advisors and tracking the S & P 500). , totaling 70% of the ETF market.

If you would like a full list of the ETFs available, send us an email or contact us by phone and we would be happy to send you the full list.

Advantages of Exchange Traded Funds or ETFs have surged in popularity since they were first introduced due to the many qualifying advantages over traditional mutual funds and individual stocks.

1) Understandable: Many ETFs track the undering index and are straightforward. For example, iShares (TM) CDN Composite Index Fund (XIC) seeks to replicate the S & P / TSX Capped Composite Index, net of expenses. StreetTracks Gold Trust tries to replicate the performance of the price of gold, minus expenses.

2) Diversification: With the click of one button, you can purchase, for example, the (XCS) iShares (TM) CDN Small Cap Index Fund which replicates the performance of the S & P / TSX Small Cap Index, net of expenses. Instead of purchasing all the different stocks within one particular sector or index and incurring the transaction costs, you can purchase one ETF that will replicate that sector or index.

3) Low Expenses: The management expense ratio (MER) for most ETFs are significantly lower then traditional actively managed mutual funds. ETFs typically charge anywhere from 0.10% to 0.70%, where a typical Canadian Equity mutual fund would charge in excess of 2.00%. In the long run, this can make a significant difference to your portfolio. It is in part this cost effectiveness that has enabled ETFs to beat around 80% of actively managed mutual funds over a five year time period.

4) Liquidity: Unlike a mutual fund that is valued at the end of the business day, ETFs are traded throughout the day and valued based on the performance of the underlying stocks within the ETF. You can buy ETFs on margin and they are Option eligible, allowing the trader more flexibility with respect to getting in and out of trades. This also helps avoid trading scandals that have plagued the mutual fund industry over the years (ie late trading and market timing scandals).

5) Flexibility: ETFs can narrow down a specific sector or industry with pinpoint accuracy. If you want to invest in a country like China, commodities like gold, or a specific industry like technology, you can do so with targeted ETFs. Not all sectors and industries perform well at the same time. You can hardly get in and out of specific industries etc. with the click of a button. They even have "Short ETFs", if you feel a particular sector or industry is set to fall, you can short it with an ETF like Horizon BetaPro Gold Bear ETF. You do not have to learn a whole new discipline like options trading, puts, calls, covered calls, naked calls, etc which can be very complex trading strategies. With ETFs, if you think a particular security or market is going to fall you can simply purchase the "Short ETF" and profit if you are correct.

ETFs can track:

– Broad Indices: TSX60, S & P500, NASDAQ, DJIA
– Sectors: gold, technology, healthcare, financial services
– Style value, growth, small cap, mid cap, sector rotator
– Countries: China, India, Russia, Brazil, BRIC countries
– Leveraged indices
– Short selling
– Fixed income investments

6) Performance: ETFs have historically outperformed mutual funds. Less a small MER (management expense ratio), ETFs will perform at its underlying index. Less then 9% of Canadian equity mutual funds outperformed their underlying index in the last 5 years according to a recent study by Standard and Poors. This study also disclosed that the average Canadian equity mutual fund underperformed it's under index by an annualized rate of 4.34%.

7) Tax Efficient: At the end of the day it is not what you make that counts; it's what you keep. This is a very important aspect of ETFs. In Canada, yearend taxable distributions are possible, but are reliably low due to low portfolio turnover. Actively managed mutual funds tend to have higher dividends, which make them less tax efficient. In the United States, due to their legal structure, most distributions from ETFs are nil. We all want to pay less money to the Canada Revenue Agency, right?

Disadvantage of ETFs: Not every investment is perfect

Performance: Because of the MER associated with ETFs, they will rarely outperform their underlying index. They will normally underperform due to the small management expense fee, plus or minus any tracking error. The fees associated with ETFs are the largest factor in tracking error.

Costs: ETFs trade like stocks. If you are buying and selling on a frequent basis, there are transaction costs or commissions associated with doing so. The more you buy and sell the higher the costs you incur, which ultimately eat into your returns.

Concentration: ETFs can be very concentrated. In some cases this may be exactly what you are looking for. In some cases it may not. Remember Nortel? At one point, it represented approximately 35% of the TSX index. We all know what happened to Nortel. Check the underlying securities of each ETF before purchasing. Not all ETFs are created equal. This information is normally readily available on the ETF sponsor's website.


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