As I explained the underlying concept of ETF’s to a colleague of mine, I thought of no better way to outline the requirements for proper ETF investing than to reference an article online – surely, someone must have broken down the need-to-knows. What should he consider before diving in? How can he make sure that he understands what he’s buying? How can he invest in the most responsible way possible?
The issue was that no sufficient sources appeared available. I wanted a report where he could evaluate the knowledge he has, and provide a reference to assist with performing a litmus test on the suitability of his investment prospects.
In lieu of that, I’ve decided to make my own post. A simple checklist for evaluating your investment/concept understanding to ensure that you’re not testing the water with both feet first.
Distilled down: The litmus test for investment suitability is the ability of an investor to describe how his money is invested, how growth is achieved, and the conditions under which his principal/returns can be affected.
1) How Your Money is Invested
It’s far too easy today to Google “Best ETF’s”, obtain a list of 500+, and then throw a few darts with your eyes tightly squeezed. However, if you don’t have an understanding of what it is that you’re buying, or where the money is actually being invested, you’ll often be surprised by the outcome. Understanding what you’re investing in – whether it be market indexes, fixed income, etc., will ensure that you have an idea of what you’re getting yourself into.
Buying market indexes (i.e. S&P, TSX) are the way most people choose to go – as the North American markets expand & grow (or retract), your ETF will be exposed to it and grow (or retract) in unison. There are other types of funds too though, and you need to understand the differences. Here is a break down:
Mirrors an equity index (either entirely or through sampling)
Allows you to gain exposure to things such as the DJIA, S&P TSX, etc. without needing to actually buy the index. The ETF holds similar companies & has similar weightings to give an index-like feel.
Mirrors specific industries/sectors (i.e. tech/automotive/etc.)
Great approach if you feel confident in the future of specific industries and want exposure.
Fixed Income ETF’s
ETF’s made up of bonds. These are great for income generation and steady cash flows.
Be wary of rising interest rates when investing in fixed income.
Tracks the price changes in commodities such as gold/silver/oil/etc.
Allows diversified exposure to commodity markets, preventing you from needing to actively select individual companies/commodities. This sector is notorious for volatility and risk so an ETF will give a way to dip your toe in.
Real Estate ETF’s (or individual REIT’s)
REIT’s are portfolios of properties (residential/commercial/industrial) that generate both rental income & capital gains. REIT’s are very interesting – learn more about them HERE.
**REIT ETF’s are exchange-traded funds comprised of various REIT’s
Funds that have specific purposes other than tracking a particular area. Specialty funds include things such as mergers & spinoffs, inverse investments (i.e. ETF’s that short a certain industry/index), feel-good funds (i.e. funds investing in socially/environmentally responsible projects), and many others. Although very narrow, these funds are an interesting way to find returns where others may not be looking or to invest in a cause that matters to you.
2) How is Investment Growth Achieved
Once you’ve done some homework and determined what sectors/industries/alternatives you want exposure too, you need to gather an understanding of how those investments make you money. Investment & portfolio growth can be achieved by means of capital appreciation, dividend income, and interest income, and it’s up to you to decide which suits you best & then proceed to find funds that offer it.
The various types of growth are accompanied by different levels of risk and different tax implications (assuming you’re investing outside of a registered account), and as such, it’s important to compare the alternatives. You can check out a simple breakdown of the three HERE. You want to make sure you take into account your holding period, risk tolerance, etc. so that you can tailor your selections.
An example of proper growth analysis would be your desire to earn both capital gains & some dividend income, in which case, you may want to look at REIT opportunities due to their high-yield and focus on growth/return of capital. This approach can be taken for any strategy and it’ll allow you to tightly control where you’re exposed.
3) Return Conditions
Now that you know what you’re investing in, and how its growth occurs, you need to figure out what the implications of such an investment are. Although far out, you’ll need to get an idea of what a future sale of your holdings may look like. A quite important, yet often overlooked aspect of ETF’s that must be examined before investment is liquidity. The liquidity of an ETF is what will allow you to sell shares (if needed) – it explains how many active buyers and sellers exist and how many shares change hands on any given day. A lack of liquidity, on the other hand, is what will allow you to lose your mind in a hurry. Compare the liquidity/daily volume on various ETF’s to get an idea of how your prospects stack up.
Next, it’s important to keep an eye on the MER of your ETF (this being the Management Expense Ratio). Explained as simply as possible, the MER is the fee you are paying to have someone else manage the ETF (which is why you’re able to buy it and do nothing afterwards). When compared to Mutual Funds, the MER on an ETF will generally be lower (depending on the type of fund, etc.), however, it’s important to keep in mind the impact these fees may have on your future returns.
Lastly, taxation implications should always be salient during the ETF selection process. If you’re buying your ETF’s in an unregistered account, you need to be aware of the taxed that may apply to the capital gains/dividend income/interest income that was touched on above and select your holdings with those in mind.
Most ETF investors fail to consider these 3 areas and find themselves down the road with large tax burdens, an inability to sell illiquid holdings, and less appreciation than they had anticipated. Perform your due diligence to make sure you’re not one of them.
ETF investing was designed to be a hands-free way for moms & pops to get their cake and eat it too, however, it’s not as easy as just throwing your money at a computer screen and watching it grow. Take some time to make sure you pass the litmus test for investing so that you can ensure your ETF selections are in your best interest, I mean, the only money manager you’ll be able to fire at the end of the day is yourself.