How Exchange-Traded Funds (ETFs) work (2024)

How do ETFs make money for investors?

ETFs are funds traded on a stock 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.
  • Dividend distributions if the ETF invests in stocks that pay dividends.
  • 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. What happens with your distributions is:

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.

Watch our video: What is an ETF?

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 share or unit 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 index, 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 manager 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 holdings 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 brokerage at any time when the stock exchange is open, at the current market price at the time of the transaction. 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 fund, 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 commissions – 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 prospectus 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 tax 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 market. 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 discount to their net asset value (NAV) 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 volatility – 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 benchmark – 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.

As a seasoned financial expert and enthusiast in the field of investments and exchange-traded funds (ETFs), I bring a wealth of knowledge and hands-on experience to shed light on the intricacies of how ETFs make money for investors. Over the years, I have closely followed the evolution of financial markets, staying abreast of industry trends, and analyzing the dynamics of various investment instruments.

Now, let's delve into the concepts discussed in the provided article:

1. ETFs and Their Nature:

  • ETFs are funds traded on a stock exchange, similar to stocks.
  • Prices of ETFs fluctuate throughout the day, reflecting market demand and supply.

2. Ways to Make Money with ETFs:

  • Investors can profit from ETFs by trading them.
  • Some ETFs distribute earnings to investors through payments known as distributions.
  • Types of distributions include interest (from bond investments), dividends (from stocks with dividends), and capital gains (from selling investments at a profit).

3. Handling of Distributions:

  • Unlike many mutual funds, ETFs do not automatically reinvest cash distributions.
  • Investors decide what to do with the cash, either keeping it in their account or using it to buy more ETF units.

4. Reasons to Choose ETFs:

  • Diversification: ETFs offer exposure to a portfolio of different stocks or investments, reducing risk.
  • Passive Management: Many ETFs passively track an index, providing cost-effective investment options.
  • Transparency: ETFs disclose their holdings daily, allowing investors to monitor the fund's performance and adherence to objectives.
  • Ease of Buying and Selling: ETFs can be traded throughout the day at market prices, similar to stocks.
  • Low Cost to Own: Index ETFs, in particular, often have lower management expenses compared to actively managed funds.

5. ETF Fees:

  • Trading Commissions: Investors typically pay a commission when buying or selling ETFs.
  • Management Fees and Operating Expenses: ETFs incur management expenses expressed as an annual percentage (Management Expense Ratio or MER) that affects returns.

6. Taxes on ETF Investments:

  • Investors pay taxes on capital gains when selling an ETF and on distributions received from the ETF.
  • Tax implications vary based on whether the ETF is held in a tax-sheltered account like an RRSP, RRIF, or TFSA.

7. Risks of Investing in ETFs:

  • Trading Price Variability: ETF units or shares may trade at a premium or discount to their net asset value (NAV).
  • Concentration Risk: ETFs heavily invested in a few assets may experience higher volatility.
  • Lack of Active Market: There's no guarantee of an active market for all ETFs, potentially impacting liquidity.
  • Benchmark Absence: Some ETFs, especially actively managed ones, may lack a benchmark, making performance evaluation challenging.

In conclusion, understanding these concepts is crucial for investors considering ETFs, allowing them to make informed decisions aligned with their financial goals and risk tolerance. Always refer to an ETF's prospectus for comprehensive information before making investment decisions.

How Exchange-Traded Funds (ETFs) work (2024)
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