How ETFs work

An exchange-traded fund (ETF)Exchange-traded fund (ETF) A fund that chooses investments based on a market index or sector. ETFs trade on a stock exchange. They are not actively managed, so costs tend to be lower than regular mutual funds.+ read full definition is an investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition fund that holds a collection of investments, such as stocks or bonds owned by a group of investors and managed by a professional money manager. ETFs tradeTrade The process where one person or party buys an investment from another.+ read full definition on a stock exchangeStock exchange A market in which securities are bought and sold.+ read full definition and can be sold short or margined. You can also trade in futuresFutures A derivative contract that commits you to buy or sell a commodity, currency or stock market index at a set price on a set date in the future. Unlike an option, you can’t change your mind later; you must do what your contract says you will do.+ read full definition and optionsOptions An investment that gives you the right to buy or sell it at a set price by a set date. The buy right is termed a “call” option, and the sell right is termed a “put” option. You buy options on a stock exchange.+ read full definition on ETFs.

ETFs and mutual funds both offer similar options to spread out risk using diversification – but they’re built, bought and sold differently.

4 things to know

  1. Risk The level of risk and return depends on what the ETF invests in. You can lose money investing in ETFs.
  2. Past performance How an ETF has performed in the past can’t tell you how it will perform in the future. But past performance can help you determine how volatile or risky the ETF’s returns may be.
  3. Buying and selling ETFs You buy and sell ETFs on a stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition exchange, in a similar way to buying and selling stocks.
  4. Fees You typically pay commissionsCommissions What you pay to a broker or agent for their services. Often called a “sales commission”. For example, you pay a fee to someone who buys or sell stocks or real estate for you.+ read full definition and management fees to investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition in ETFs. There may also be costs to set up an investment accountAccount An agreement you make with a financial institution to handle your money. You can set up an account for depositing and withdrawing, earning interest, borrowing, investing, etc.+ read full definition.

How to make money on an ETF

Some ETFs pay out the money the ETF makes to investors. These payments are called distributions. For example, you may receive:

  • interest distributions if the ETF invests in bonds,
  • dividendDividend Part of a company’s profits that it pays to shareholders in proportion to the total number of shares held. The Board of Directors sets the amount. For common shares, the amount varies. It may skip dividends if business is poor or the directors invest money in things like new equipment or buildings.+ read full definition distributions if the ETF invests in stocks that pay dividends, or
  • capital gains distributions if the ETF sells an investment for more than it paid.

Unlike many mutual funds, ETFs do not reinvest your cash distributions in more units or shares. Here’s what happens with your distributions instead:

  1. The cash stays in your account until you tell your investment firm how you want to invest it. You may have to pay a sales commission on what you buy.
  2. Your investment firm may offer a program to automatically buy more ETF units or shares for you. You likely won’t pay a sales commission on these automatic purchases.

How ETFs are taxed

You’ll pay taxTax A fee the government charges on income, property, and sales. The money goes to finance government programs and other costs.+ read full definition on:

  • any capital gains you make from an ETF when you sell it, and
  • any distributions you receive from the ETF.

If you hold an ETF inside a tax-sheltered account such as an RRSP or a RRIF, you won’t pay tax on what you make investing until you take the money out. With a TFSA, you won’t pay any tax on the money you make while it’s in plan or when you take it out. Learn more about how investments are taxed.

Key point

Like a mutual fundMutual fund An investment that pools money from many people and invests it in a mix of investments such as stocks and bonds. A professional manager chooses investments that match the fund’s goals for risk and return. You can redeem your fund units at any time.+ read full definition, an ETF holds a variety of investments. But it trades on a stock exchange like a stock.

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