An exchange-traded fund (ETF) is a collection of assets, such as stocks or bonds, that trades on an exchange. There are many types of ETFs. Find out more.
There are many types of ETFs. Each one has pros and cons to consider if you’re adding to your investment portfolio. Before you invest, it’s a good idea to read the fund’s prospectus and ETF Facts carefully to understand how the product works and its risks. Consider your risk tolerance and investment strategy before making a decision.
What are index ETFs?
Index ETFs follow a benchmark, such as a stock market index (for example, the TSX/S&P 60). They are index-tracking investments. An Index ETF does not try to outperform its benchmark index. 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, fees and expenses, taxes (for foreign holdings) and trading and rebalancing costs 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.
What are 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 chosen by the fund’s portfolio manager. 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 risks of actively managed ETFs include paying higher fees for the reliance on the skills and judgement of the portfolio manager. There is no guarantee that returns will be higher than a lower-cost passive index ETF and the higher fees can reduce your overall returns.
An actively managed EFT may overperform or underperform based on portfolio manager choices such as the selection of securities, the weighting in various sectors, and market opportunity timing or anticipating the impact of geopolitical or economic developments. When you buy an actively managed ETF, you are trusting the fund manager to make good decisions. And, if success is tied to a particular portfolio manager who then leaves, the future performance of the ETF may be impacted.
Actively managed ETFs may also have a concentration risk as the ETF may hold fewer securities than a broad index ETF. There is also trading and turnover risk since actively managed funds tend to trade more frequently.
An actively managed ETF buys and sells investments based on the ETF’s investment objective and the portfolio manager’s strategy.
What are 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. Leveraged ETFs can be tied to all kinds of different asset classes (i.e., indices, such as the S&P 500, single stocks and commodities such as crypto and gold, etc.,), each with their own varying levels of volatility.
The objective of leveraged ETFs 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 (the amount of leverage) in line with the actual stock owned.
The “daily reset” feature of leveraged ETFs can be a point of confusion for some investors. You may think you should be receiving 2x or 3x the underlying securities performance depending on how your leveraged ETF performs over the time it is held. But because of the “daily reset” compounding is affected, creating a drag on returns over the longer term. The higher the volatility and leverage, the larger the “volatility decay” will be, sapping returns over the time period.
How a leveraged ETF moves in price over a period of time is also relevant to its return, not just the end price. This is called the path dependency of returns. For example, even if you are correct in your determination about the market, you may not receive the same performance of the assets in your leveraged ETF structure as you would in another structure such as a margin account. The key point to remember is that leveraged ETFs are only suitable as a day-trading tool and should not be held over long periods of time.
In Canada, there are also “inverse” leveraged ETFs where an investor will come out on top if the reference asset/index goes down in value.
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 daily reset feature. 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. For example, if a 2x leverage ETF declines 50% in one day, you will lose 100% of your investment.
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. Learn more about borrowing to invest.
What are 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
What are specialty ETFs?
These ETFs focus on a specific asset or action. 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.
7. Foreign ETFs
Canadian investors can purchase units of ETFs that are listed in Canada, as well as ETFs that are listed in foreign countries, such as the United States. Investors should consider several things before investing in foreign ETFs. On one hand, foreign ETFs may provide Canadian investors with exposure to a broad range of assets, including assets that Canadian ETFs do not invest in.
On the other hand, investing in foreign ETFs has consequences, including currency risk, which refers to the possibility that changes in currency exchange rates will lower overall investment returns, and different tax treatment. Canadian tax law treats investments in Canadian ETFs differently than investments in U.S. ETFs. It is very important for investors to understand the tax implications of investing in a foreign ETF before deciding to invest. Before investing, investors should also compare foreign-listed ETFs with Canadian ETFs that either have similar investment objectives and strategies or that invest in similar assets. Find out more about foreign-listed ETFs.
8. Crypto ETFs
Crypto ETFs invest up to 100% of their assets in a particular cryptocurrency. The cryptocurrency is usually referenced in each ETF’s name.
Purchasing units of a crypto ETF differs from purchasing the underlying cryptocurrency directly because the ETF’s fund manager will usually engage in additional strategies to earn income for investors. Such strategies can include the use of leverage and writing covered call options.
9. Single-Stock ETFs
Each of these ETFs will invest up to 100% of its assets in shares of a single issuer. Unlike most ETFs and investment funds, single-stock ETFs do not hold securities from multiple issuers, but only those of a single issuer. The names of each ETF will include the name of the issuer whose shares the ETF will be purchasing.
Purchasing a single-stock ETF differs from purchasing the underlying issuer’s shares directly because the ETF’s fund manager will usually engage in additional strategies to earn income for investors. Such strategies can include the use of leverage and writing covered call options.
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 is a collection of assets, such as stocks or bonds, that trades on exchange. 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.
