Ever since Exchange-Traded Funds (ETFs) were popularized in the 1990s, a recurring, natural question we hear is, “Should I own ETFs?” The question is often followed by the sentiment that maybe all one needs to do to reach one’s financial goals is to set up a discount brokerage account and buy a few good ETFs.
In many ways, low-cost ETFs can indeed contribute to achieving your financial goals. But rather than concluding that they are THE answer to all your investment needs, it’s better to view them as simply one more tool within your overall investment “project.” Just as the answer to, “Should I use a hammer?” depends on whether you are looking at a nail or a window pane, the question, “Should I own ETFs?” depends on a number of factors worth considering before you leap.
What Is an Exchange-Traded Fund (ETF), anyway?
Similar to a mutual fund, an ETF is a collection of holdings such as stocks, bonds or other securities that can be bought and sold on a public exchange. Investors purchase ETF shares hoping the price of the fund will increase based on its adept trading of its underlying securities.
Something like index funds, ETFs usually seek to invest in a basket of securities that share particular commonalities. These commonalities can be familiar ones, such as buying and holding a traditional index like the S&P/TSX Composite index which tracks Canadian stocks or the S&P500 index which tracks US Stocks. Or they can be burdened with layers of complex leveraging strategies, and/or fancied up to capture obscure market niches ranging from fishing interests to European Union Allowances and Certified Emission Reduction Credits.
Perhaps the most widely recognized difference between ETFs and traditional mutual funds is that ETF share prices fluctuate and can be traded on throughout the day. With mutual funds, regardless of when you buy or sell during a market day, you receive the same, end-of-day closing price. Sometimes, this “feature” is touted as an investment advantage. But just because you can try to time the market, doesn’t mean you should. For long-term investors who want to build durable wealth rather than wheel and deal in split-second market moves, this detail shouldn’t matter.
What to Seek in an ETF
Quality ETF investments should be low-cost, transparent, tax-efficient and liquid (readily tradable). Their costs, underlying holdings and management should be relatively transparent, so you can see what you’re getting yourself into.
ETFs that are narrowly focused or concentrated, or that turn to opaque, risk-laden use of leverage or derivatives do not tend to lend themselves to the overarching goal of achieving your financial goals. Instead, they tend to be loaded with higher embedded costs. They may demand premiums beyond their net asset value, be difficult or impossible to trade, and often are tax inefficient or otherwise costly as a result of participating in illiquid markets. Other idiosyncratic risks hidden within them can be difficult to identify, making them ill-suited for a carefully managed portfolio.
Should You Own ETFs?
So, should you own ETFs? The answer is, maybe. First, not all ETFs are created equal. Second, it depends on your financial goals and circumstances.
Bottom line, the function of any reliable tool – including ETFs – should be to help you build and manage your low-cost, globally diversified portfolio according to your personal goals and risk tolerances. As such, the tool itself doesn’t remove the additional, critical need to be familiar with how to construct and stick with your carefully considered portfolio in the face of the market’s inevitable ups and downs. A quality hammer in the wrong hands can still cause plenty of damage.