An exchange-traded fund (ETF) holds a collection of investments, such as stocks or bonds owned by a group of investors and managed by a professional money manager.
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There are many different types of ETFs. Each one has pros and cons to consider if you’re adding to your investment portfolio. Read the fund’s prospectus and ETF Facts carefully to better understand how the product works and its risks. Consider your risk tolerance and investment strategy before making a decision.
Watch our video: What is an ETF?
Index ETFs
Index ETFs follow a benchmark, such as a stock market index (for example, the TSX/S&P 60). They are passive investments. They closely track an index. An Index ETF does not try to outperform the benchmark. The fund’s holdings are only adjusted if there is an adjustment in the components of the index.
Not all index ETFs follow stock market indices. Fixed-income ETFs, for example, follow indices that track bonds. Index ETFs can also track a specific commodity like oil or gold, or single countries or regions
The specific index that an ETF tracks is important because it determines how investments are weighted in the fund. Two indices with the same investments in different proportions will provide different returns.
What are the risks with index ETFs?
Index ETFs have risks similar to the investments in the index they track. For example, an ETF that follows an equity index has risks similar to stocks. An ETF that follows a fixed-income index has risks similar to bonds.
An index ETF may not achieve the same return as the index or sector it tracks. That’s because the weighting of investments in the ETF may not be the same as those in the index, and fees and expenses lower the ETF return.
Like an index ETF, index mutual funds also track an index. But you buy and sell index mutual funds through a mutual fund dealer — usually your bank or mutual fund company. With Index ETFs, you have to open a trading account because you buy and sell ETFs on an exchange like stocks.
Actively managed ETFs
Actively managed ETFs do not track an index. Instead, they try to meet a particular investment objective by investing in a portfolio of stocks, bonds or other assets. Active ETFs, like actively managed mutual funds, have more turnover than index ETFs because a portfolio manager actively trades the investments in the portfolio.
What are the risks of actively managed ETFs?
The risk of actively managed ETFs include that it may be difficult to find an appropriate benchmark to monitor ETF performance. That’s because active ETFs can be flexible in terms of what they invest in.
Actively managed ETFs also carry the additional risk of front running. Some ETFs disclose their holdings every day — that means everyone can see where an active ETF’s portfolio manager is putting the fund’s money and, if they want, they can try to replicate the fund’s holdings. This process can drive a stock’s price up higher as many investors try to copy the strategy of a particular manager.
An actively managed ETF buys and sells investments based on the ETF’s investment objective and the portfolio manager’s strategy.
Leveraged ETFs
Leveraged ETFs are highly speculative short-term investments. These ETFs use leverage — they borrow to increase the amount that they can invest in the market. The objective of these funds is to double or triple the daily return of an index. This means the ETF must rebalance — or “re-leverage” — its position every day to keep the amounts borrowed in line with the actual stock owned.
What are the risks of leveraged ETFs?
Leveraged ETFs carry the same risks as other ETFs, but they also carry additional risks that make them highly speculative. As with any leveraged investment, your potential gains are multiplied — but so are your potential losses. If the ETF aims to double or triple the return of the index it’s tracking, and the market moves in the wrong direction, your losses will be doubled or tripled. For example, if the ETF’s objective is to triple the index, and the index drops by 10%, the share value of the ETF will fall by 30%.
Leveraged ETFs are riskier over the long term due to the constant leveraging and rebalancing if the fund returns don’t meet the daily objectives. If returns vary widely from day to day, over time you’ll lose money even if the underlying index breaks even.
As with any leveraged investment, your potential gains are multiplied – but so are your losses if the index moves the other way. You can never lose more than the amount of your original investment, but you can lose all of it.
Leveraged ETFs are best suited to institutions and sophisticated investors who trade daily and can afford to take on the added risks.
Leveraged ETFs are highly speculative short-term investments. They are not appropriate for investors who are planning to hold their investment for longer than a day – especially in volatile markets.
Volatility-linked ETFs
Volatility-linked ETFs are high-risk, complex investments. Volatility-linked ETFs are bets for or against volatility in the stock market. Some of these products do well when there are major swings in the market such as a stock market crash while others do well when the market is stable and there are no major changes.
These products are typically suited for financial professionals or investors who understand advanced investing strategies and are willing to take significant risk, including the possibility of losing their entire initial investment.
The Chicago Board Options Exchange publishes the Volatility Index or VIX which measures expected stock market volatility by looking at current S&P 500 option prices. A higher VIX value means more volatility is expected. This is sometimes called the “fear index” but what it really represents is how much stock prices are expected to move (up or down) over the next 30 days.
Since the actual VIX cannot be bought (it’s simply an index), most volatility-linked ETFs are based on VIX future contracts, which is a bet on what the value will be on a future date.
What are the risks of volatility-linked ETFs?
You could risk major losses if you buy and sell volatility-linked ETFs without fully understanding how they work. Unlike most ETFs, volatility-linked ETFs are meant for short-term trading. This could mean owning the investment for mere hours. Some funds strongly advise against holding the product for more than one day.
Holding volatility-linked ETFs for the long term will likely expose you to even greater risks and further increase the likelihood of losing your money.
If you want to invest in a volatility-linked ETF, make sure you understand that:
- These investments are high risk
- They may not match how the stock market performs, since VIX future contracts are based on future expectations, not current performance
- Their investment strategies may be more complex than other products, and it may be difficult to predict how the fund would react to a sudden market shock
- They are different from most other ETFs, as they are designed for short-term trading
Specialty ETFs
These ETFs focus on a specific asset or action. Six of the most common types of specialty ETFs are:
1. Commodity ETFs
These ETFs invest in physical commodities like precious metals, natural resources, and agriculture. They work either by holding and storing the commodity they invest in (for example, gold or grain), or by tracking a commodity index through physical holdings and derivatives.
Risk: Commodity ETFs tend to be higher risk because they are concentrated in one sector and the prices of commodities move frequently.
2. Inverse ETFs
An inverse ETF allows investors to short an index. It’s called inverse because it profits when the index declines. For example, if an index falls 10% the inverse ETF based on it would rise 10%.
Risk: Inverse ETFs can be risky for investors who hold them for too long. They are designed for day-to-day use and investors should monitor their performance daily.
3. Currency ETFs
Currency ETFs invest in a single currency (for example, the U.S. dollar) or basket of currencies (for example, emerging markets). The goal is to follow the movements of those currencies in the foreign exchange market.
Risk: Currency ETFs can be risky. If the underlying currency experiences big changes in price, you could lose money.
4. Covered call ETFs
These ETFs write covered calls (sell call options on the stocks that the ETF owns) to generate additional income (in the form of premiums). The call option buyer buys the option to buy the stock from the ETF at the predetermined price in the future.
Risk: They’re designed to provide income but covered call ETFs do have risks. For example, if the stock price increases dramatically, the ETF would lose the opportunity to profit from the price increase beyond the predetermined price of the corresponding call option.
5. Managed futures ETFs
Managed futures ETFs use commodity futures (speculating on the future price of commodities such as natural gas or copper) to deliver positive returns in both up and down markets. They do so by taking both short and long positions to follow market trends.
Risk: If the markets don’t follow the predicted short and long positions, you could lose money.
6. Hedge fund ETFs
Hedge fund ETFs aim to mirror the stock picks of major hedge funds. These ETFs use monthly published data on the holding of particular hedge funds.
Risk: Hedge funds often buy and sell their holdings quickly (day-to-day). By the time the holdings are published, the ETF might not be an accurate reflection of the underlying fund. And there might be greater volatility in difficult market conditions.
Stock market indices track the activity of a specific part of the market. Learn more about how the stock market works.
Summary
An ETF is an investment fund that holds a collection of investments, such as stocks or bonds, owned by a group of investors. There are different types of ETFs with different types of assets.
- ETFs, like any other investment, do carry risk. Consider your risk tolerance and investment strategy before making a decision.
- Some ETFs are designed for short-term investing and are more speculative.
- Always understand the fees involved when adding ETFs to your investment portfolio.
- Read the fund’s prospectus and ETF Facts carefully to better understand how the product works and its risks.
