ETF EDUCATION CENTRE

What is an exchange-traded fund and why should I care?

Let's break down "exchange-traded fund" into its core elements. The word "fund" is similar to mutual fund in that it owns a basket of stocks. "Exchange-traded" means that the fund is a security that you can buy and sell on a major stock exchange. So when you buy into an ETF, you do not own a single stock, but rather a collection of many companies.

A grocery analogy will explain it better: When you go to the grocery store, you don't buy, just milk or eggs, but you usually also pick up butter, flour, a loaf of bread, vegetables, fruit and maybe a few canned goods. An ETF is similar, except instead of groceries, it is a basket of stocks.

ETFs are actually a Canadian invention. In 1990, the Toronto Index Participation Units - dubbed TIPs - were launched and tracked the 35 largest companies on the Toronto exchange at the time. Americans got into the game three years later when State Street Corp. teamed up with the American Stock Exchange to create a fund that tracked the value of the S&P 500 index.

Since then, ETFs have quickly become an important part of world financial markets and an increasingly popular investment. According to Morgan Stanley, ETFs owned US$796.60-billion worth of assets at the end of 2007, a 41% boom over the year before. At the end of the year, there were 1,909 funds - a 64% increase from 2006. The U.S. is the largest ETF market, with 601 funds owning US$580.71-billion worth of assets.

As of January 1, 2008, the Canadian ETF market had 75 funds owning $17-billion worth of shares. There are now ETFs that track sectors (a Canadian agricultural ETF, called the Claymore Global Agricultural ETF - COW/TSX), certain geographical markets (emerging market ETFs such as the iShares MSCI Brazil Index - EWZ/NYSE) and even obscure interests like luxury brands (e.g. the Claymore Robb Report Global Luxury ETF - ROB/NYSE - is a fund that tracks the biggest luxury brands including Porsche, Louis Vuitton and Polo Ralph Lauren).

Why are they so popular? For one, they're cheap. ETFs are like mutual funds in that they own a basket of stocks and so investors feel comfortable knowing they're not over-exposed to only one company and feel diversified. However, ETFs charge a fraction of the fees: Big-name ETFs generally charge management expense ratios (MERs) of less than 1% while the average mutual fund charges 2.5%. ETFs are cheaper because they're "passively managed" as opposed to the "actively managed" mutual funds - ETFs passively track an existing index while mutual funds have appointed experts billing expensive time for their research as they actively decide which stocks to buy and sell.

But ETFs are also popular because they often do better than the expensive mutual fund managers who are paid to pick stocks. Less than a fifth of mutual funds beat the index over the long run, so why not just buy the ETFs that mirror major indexes and outperform the stock pickers? Indeed, investors have done exactly that in recent years, which is why the ETF market has ballooned as it has.