How Exchange-Traded Funds (ETFs) work

An exchange-traded fund (ETF)Exchange-traded fund (ETF) An investment fund that holds a collection of investments such as stocks and bonds, that trades on a stock exchange. It can be passively managed or actively managed.+ read full definition 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.

When you investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition in an ETF, you do not own the actual securities (i.e., stocks, bonds), but you do own shares in the fund.

ETFs are frequently compared to mutual funds. Both ETFs and mutual funds are ways to invest in a collection of investments and diversify a portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition. But they’re built, bought and sold differently. ETFs are available from an investment dealerInvestment dealer A securities firm that buys and sells a wide range of investments. They are likely a member of the Investment Industry Regulatory Organization of Canada (IIROC).+ read full definition or through online trading platforms.

Watch our video: What is an ETF?

On this page we answer:

How do ETFs make money for investors?

ETFs are funds traded 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. Their prices will fluctuate throughout the day, like stocks do.

You can make money from ETFs by trading them. And 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.
  • Capital gains distributions if the ETF sells an investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition for more than it paid.

Unlike many mutual funds, ETFs do not reinvest your cash distributions in more units or shares. What happens with your distributions is:

1. The cash stays in your 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 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.

Why do some investors choose ETFs?

There are several reasons why you might want to invest in an ETF including:

1. Diversification

When you buy a shareShare A piece of ownership in a company. A share does not give you direct control over the company’s daily operations. But it does let you get a share of profits if the company pays dividends.+ read full definition or unitUnit What you buy when you invest in mutual fund. Similar to a share of a stock. For example, you could buy 100 units in a mutual fund.+ read full definition of an ETF, you’re investing in a portfolio that holds several different stocks or other investments. This diversification may help smooth out the ups and downs of investing. You can also spread your money among ETFs that cover various investments, such as bonds or commodities. This allows you to further diversify.

2. Passive management

Most ETFs are designed to track an indexIndex A benchmark or yardstick that lets you measure the performance of a stock market, part of a stock market or a single investment. Examples: S&P/TSX, S&P/TSX Canadian Bond Index.+ read full definition, such as the S&P/TSX 60. This is called passive investing. Passive investing tends to cost the consumer less compared to active investing. That’s when a portfolio managerPortfolio manager An investment professional who manages your investment portfolio. For example, they buy, sell and monitor investments that fit their clients’ goals and tolerance for risk.+ read full definition actively buys and sells securities to try to outperform the market. There are advantages to active strategies, but passive strategies can outperform active investing based on cost savings alone.

3. Transparency

Most ETFs publish their holdingsHoldings Shares or other interests in a business. Also refers to investments in a portfolio.+ read full definition every day. You can see what investments your ETF holds, their relative weighting in the fund and if the fund has changed its position in any particular investment. This transparency can help you tell if an ETF is meeting its investment objectives. You can usually find out what investments an ETF holds, and their relative weighting in the ETF, on a more frequent basis than for mutual funds, which only disclose their holdings periodically.

4. Ease of buying and selling

You can buy and sell ETFs from an investment firm or online brokerageOnline brokerage A brokerage firm that lets you make your own investment choices and carry them out over the internet. You pay lower fees than if you used a full-service broker.+ read full definition at any time when the stock exchange is open, at the current market priceMarket price The amount you must pay to buy one unit or one share of an investment. The market price can change from day to day or even minute to minute.+ read full definition at the time of the transactionTransaction The process where one person or party buys goods or services from another for money. Examples include taking money out of an account, buying something with a credit card or taking out a loan.+ read full definition. Like stocks, ETFs are traded throughout the day at the current market price. You’ll usually pay a commission when you buy or sell an ETF.

Unlike 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, which is only priced at the end of the trading day, ETFs are traded throughout the day at the current market price. You can find the current market price for ETFs at any time, while mutual fund prices are usually only available once daily.

5. Low cost to own

You may pay less to own an ETF than a mutual fund, depending on the fund you buy. Index ETFs, for example, simply track an index, so the portfolio manager doesn’t actively manage the fund, which can mean a lower management expense ratio (MER).

Actively managed ETFs and leveraged ETFs have higher MERs than index ETFs, but may have lower MERs than actively managed mutual funds.

What kind of fees do ETFs have?

Most ETFs have fees that are lower than a typical mutual fund but cost more compared to owning a stock. There are 2 main types of ETF fees:

1. Trading 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 – Like a stock, you will usually pay a commission to the investment firm every time you buy or sell an ETF. Consider how these costs will affect your returns if you’re planning to make frequent purchases or trade often.

2. Management fees and operating expenses – Like a mutual fund, ETFs pay management fees and operating expenses. This is called the management expense ratio (or MER). MERs for ETFs are usually lower than those for mutual funds in the same class. They are paid by the fund and are expressed as an annual percentage of the total value of the fund. While you don’t pay these expenses directly, they affect you because they reduce the fund’s returns. This can add up over time.

You pay commissions to buy and sell ETFs, so if you plan to trade frequently, these costs will impact your return. You will also pay management expenses regardless of how the fund performs, even if the fund has negative returns.

Before you invest, read the ETF’s prospectusProspectus A legal document that sets out the full, true and plain facts you need to know about a security. Contains information about the company or mutual fund selling the security, its management, products or services, plans and business risks.+ read full definition or its summary disclosure document to understand the fees. You can find these documents on the ETF manager’s website.

Visit our ETF facts interactive sample to see the information you should know before you invest.

You can compare fees and performance online at websites like Globefund and Morningstar.

What kind of taxes will you pay on ETF investments?

When you invest in ETFs, 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.
  • 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 until you take the money out. With a TFSA, you won’t pay any tax while it’s in a plan or when you take it out. Learn more about how investments are taxed.

Because ETFs are traded on stock exchanges, this means their performance will rise and fall along with the stock marketStock market The collection of markets and exchanges where stocks, bonds and other securities are issued or traded.+ read full definition. Learn more about how the stock market works.

What are the risks of investing in ETFs?

The level of risk and return of a specific ETF depends on the type of fund and what it invests in. Risks can include:

1. The trading price of units or shares can vary – Units or shares may trade in the market at a premium or discountDiscount When something sells for less than its normal price.+ read full definition to their net asset value (NAV)Net asset value (NAV) The amount that a single mutual fund unit is worth in dollars. It is based on the value of the assets of the fund, less the fees, expenses and taxes, divided by the number of units in the fund.+ read full definition because of market supply and demand. The premiums and discounts for specific ETFs vary, depending on the type of ETF and time period.

2. Concentration can lead to volatilityVolatility The rate at which the price of a security increases or decreases for a given set of returns. A stock price that changes quickly and by a lot is more volatile. Volatility can be measured using standard deviation and beta.+ read full definition – If an ETF is heavily invested in only a few investments or types of investments, it may be more volatile over short periods of time than a more broadly diversified ETF.

3. There may not be an active market – Although an ETF may be listed on an exchange, there is no guarantee that investors will buy its units or shares. That means you may not be able to sell your ETF when you want to. An active market may not develop or be sustained for the ETF.

4. Some have no benchmarkBenchmark A yardstick that you can use to measure the performance of an investment. Example: a stock market index may be a benchmark you can use to compare how well your own stocks are doing.+ read full definition – Some ETFs are indexed, which means it is easier to track their performance against a benchmark. However, this is not true of all ETFs. Active ETFs, for example, may not be designed to track an index so it’s hard to compare performance over time.

Each type of ETF has its own set of risks. Learn more about the risks of different types of ETFs.

Summary

Exchange-traded funds are traded on a stock exchange like a stock. Considerations include:

  • Similar to mutual funds, ETFs contain a collection of investments such as stocks or bonds.
  • Like most investments, there’s no guarantee that you’ll make money with an ETF.
  • Investing in ETFs involves paying fees, which may be less than some investments but higher than others.
  • You will have to pay taxes on capital gains and distributions.
  • Before you invest, read the ETF’s prospectus or its summary disclosure document to understand its investment objective, investment strategies, risks, fees and historical performance.

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