ETFs - What are They Good For?

ETFs are in the news these days. Jonathan Chevreau's November 6th column at the National Post described the curious situation of significant net withdrawals in September and October by Canadian investors from mutual funds while certain Exchange Traded Funds (ETFs) saw large net purchases.

Their being in the limelight does raise the question of what ETFs are, their strong and weak points and why they might be attractive to an investor.

What are ETFs?
Exchange Traded Funds are funds that hold numerous individual stocks or bonds. ETFs are bought and sold as shares on stock exchanges (thus the name). Each share owns a tiny part of dozens, hundreds or even thousands of individual stocks or bonds. ETFs are built to copy the compostion of an index, such as the TSX60, the S&P500, the Dow Jones or some other index, such as the UK FTSE, the Eurozone, the Far East, commodities, currencies, large/small companies, or sectors such energy, mining, financials, real estate etc.

The number and variety of ETFs is growing steadily. As of early November 2008, there are over 800 US-exchange traded ETFs and 60-odd Canadian-traded ETFs available to a Canadian investor through any discount broker.

More background:

• Canadian FinancialDIY on ETF Screeners, Tools and Primers
• Seeking Alpha's ETF Resource Page
• Shakespeare Discusses ETFs and Compares Them to Index Mutual Funds
• Stock-Encyclopedia.com lists all US and Canadian ETFs in one place
• The New Investment Frontier III, detailed and practical book sub-titled A Guide to Exchange Traded Funds for Canadians by Howard J. Atkinson with Donna Green
  

Strengths and Weaknesses of ETFs
The following chart should be self-explanatory, except for the last line, which is deliberately repeated! An index fund will necessarily do no better (actually, a little less by the amount of costs the fund incurs) than the index it tracks, the average of that particular market. That is bad in the sense that you will never get rich quick through amazing returns. But it is good in the sense that the vast majority of mutual funds over any extended period of years under-perform the market (see the latest results from Standard and Poor's SPIVA Canada Scorecard where for example, only 6% of activle-managed Canadian equity mutual funds outperformed the TSX index over the past 5 years ).

What ETFs are Best Suited For
Given their characteristics in comparison to individual stocks and bonds and mutual funds, here is how I believe ETFs can most be most useful to an individual investor:

• Buy and hold passive investing with low time and attention needed for portfolio management
• Portfolio-oriented investing where diversification, deliberate asset allocation with non-overlapping funds, infrequent rebalancing (max once a year) and risk control are key to the investment approach
  
• Long-term investing
• Fixed income bond holdings (and like all fixed income, ideally held within a registered account to minimize tax from interest income)
• Equity holdings in taxable accounts
• Larger new amounts to add to a portfolio (e.g. a $10 commission on a $1000 purchase is 1% initial cost, about the max I would accept for myself)
• Larger market cap equity holdings and developed country markets, since these are the most efficient and where it is most likely that mutual funds will not outperform; conversely, small caps and emerging markets are where mutual fund managers have better chances of outperforming

Whether it is the inherent qualities of ETFs or some other factor that caused people to buy them while mutual funds were being sold off recently is open to debate but their value and usefulness is certain.