What Is an ETF and How to Invest in ETFs in Canada?

In today's investment landscape, Exchange Traded Funds (ETFs) have become an indispensable component, earning global investors' favor with their unique flexibility and efficiency. As an investment tool that combines the trading convenience of stocks with the broad risk diversification of mutual funds, ETFs not only provide individual investors with access to complex financial markets but also promote liquidity and transparency in the capital markets.

For Canadian investors, ETFs have become an important tool for building and managing investment portfolios, with their easy operation, low cost, and rich investment options, making them one of the top choices for those seeking stable value growth and asset allocation optimization.

As the market evolves and technology advances, the investment status of ETFs in Canada is becoming increasingly prominent, gradually changing people's financial management methods and investment concepts.

What is an ETF?

Exchange-Traded Funds (ETFs) are a type of investment fund that are traded on stock exchanges, similar to the way individual stocks are bought and sold. ETFs aim to track the performance of specific indices (such as the S&P 500), commodities, bonds, or a basket of assets. ETFs also calculate their Net Asset Value (NAV) every trading day, but this is not their trading price. ETFs can be traded in real-time during trading hours, and their trading prices fluctuate in real-time as well. However, generally speaking, their trading prices are very close to their NAV.

How do ETFs Work?

The operation of ETFs includes three parts: the creation and redemption of shares in the primary market, the trading of shares in the secondary market, and the arbitrage mechanism that exists based on the trading rules of the first two markets.

Primary Market - Creation and Redemption of Shares

Creation and Redemption: ETF shares are created and redeemed through Authorized Participants (APs), which are typically large financial institutions. APs create new ETF shares by purchasing the underlying assets in the portfolio and delivering them to the ETF issuer. In return, they receive ETF shares. Conversely, APs can redeem ETF shares for the underlying assets.

Purpose: Mainly used to create new ETF shares or reduce existing shares to maintain the balance of supply and demand for ETF shares.

Price: Based on the net asset value (NAV) of the fund .

Participants: Typically large institutional investors, professional investors, or Authorized Participants. Individual investors participate less due to high capital thresholds.  

Secondary Market - Trading and Circulation of Shares

Once ETF shares are created, they can be bought and sold on stock exchanges throughout the trading day, just like individual stocks. This allows investors to trade ETFs at different prices throughout the day, depending on supply and demand.

Purpose: Mainly used for trading between investors to achieve quick buying and selling and circulation of ETF shares.

Price: Determined by market supply and demand, which may have a slight deviation from the fund's net value.

Participants: Including individual investors, institutional investors, and various other market participants.

Arbitrage Mechanism

Purpose: To trade between the primary and secondary markets to bring the ETF's market price back to its net value, thereby maintaining the stability of the ETF's price.

Premium Arbitrage: When the secondary market price of an ETF is higher than its net asset value(NAV), Authorized Participants (APs) exchange a basket of securities for ETF shares in the primary market and then sell the ETF shares in the secondary market at the market price to earn the price difference.

Discount Arbitrage: When the secondary market price of an ETF is lower than its net asset value(NAV), Authorized Participants (APs) buy ETF shares at the market price in the secondary market, then redeem the ETF shares for a basket of securities in the primary market, and finally sell these securities in the secondary market to earn the price difference.

Types of ETF

Facing the multitude of ETFs in the market, they can be categorized in many ways based on their different attributes. Below are some types of ETFs that investors commonly encounter:

Index ETFs

Most ETFs are designed to track and replicate the performance of an established market index, and these can be referred to as index ETFs. Common examples include S&P 500 ETFs. However, the indices they track are not limited to stock indices; they also include bond indices and others.

Money Market ETFs

These primarily invest in money market instruments, such as short-term Treasury bills and commercial paper. These types of ETFs have the characteristics of low risk and high liquidity, making them suitable for short-term cash management.

Equity ETFs

These primarily invest in the stock market and track specific stock indices. This type of ETFs can also be further divided based on other attributes of a basket of stocks, such as ETFs that track specific sector indices (e.g., Healthcare Sector ETFs, Technology Sector ETFs), and ETFs that track specific themes (e.g., AI ETFs).

Bond ETFs

These primarily invest in the bond market and track bond indices. They can be further divided into Treasury ETFs, Corporate Bond ETFs, and Convertible Bond ETFs.

Commodity ETFs

These primarily invest in the commodity market and track commodity prices or indices. Based on the types of commodities, they can be further subdivided, for example:

• Precious Metals ETFs: Such as Gold ETFs or Silver ETFs.

• Agricultural Commodities ETFs: Such as Soybean Meal ETFs or Corn ETFs.

• Energy ETFs: Such as Oil ETFs or Gas ETFs.

Benefits of Investing in ETFs in Canada

Investing in ETFs has the following benefits:

Diversification

ETFs typically track the performance of a basket of stocks, holding a diversified portfolio of assets, which avoids the volatility impact of holding a single security and helps to spread risk.

Cost Effectiveness

The management fees and operating expenses of ETFs are generally lower than those of mutual funds. The lower costs can significantly enhance net returns, making them particularly suitable for cost-sensitive investors.

Liquidity and Flexibility

ETFs trade on secondary markets like stocks, allowing investors to use various trading strategies, including stop orders, limit orders, and margin trading. This provides liquidity for ETF trading while enhancing the flexibility of investor transactions.

Transparency

ETFs disclose their holdings on a daily basis, providing clear information about the composition of assets. This level of transparency allows investors to understand exactly what they are investing in, which helps them make more informed decisions.

Tax Efficiency

Due to the unique operational model of ETFs, they generate less capital gains. On the one hand, ETFs are typically passively managed, with a lower frequency of buying and selling the stocks in their holdings; on the other hand, the trading of ETF shares on the secondary market does not involve the creation or redemption of ETF shares, so fund managers do not have to sell stocks to realize gains. Based on these two points, ETFs usually result in less taxable capital gains.

ETFs vs Mutual Funds

ETFs and mutual funds share some common characteristics: they both offer investors diversified portfolios, not limited to a single stock; they are both managed by professional fund managers; and they both come in various types, providing investors with a broad range of strategic options. However, for investors, understanding their differences is more important, as it directly affects investment decisions.

Trading Method

ETFs: Investors can buy and sell ETF shares at any time during the trading day, with prices fluctuating based on market supply and demand.

Mutual funds: Mutual funds have only one trading price per day, which is the net asset value (NAV) of the fund, usually calculated after the market closes each trading day.

Fees

ETFs: Management fees are relatively low, but there may be transaction fees such as commissions.

Mutual funds: Management fees are typically higher, especially for actively managed funds, as fund managers need to conduct frequent trading and research. There may also be redemption fees.

Management style

ETFs: Most ETFs are passively managed, aiming to replicate the performance of a specific index, with lower management fees. However, there are a few actively managed ETFs.

Mutual funds: Most mutual funds are actively managed, with fund managers selecting and adjusting the portfolio based on market conditions and investment strategies. However, there are also passively managed mutual funds that track a specific index.

Transparency

ETFs: Relatively higher, as ETFs disclose their holdings every trading day, allowing investors to clearly understand their investment portfolio.

Mutual funds: Relatively lower, as mutual funds typically disclose their holdings and related data indicators only once every quarter.

How to choose the best ETFs?

For every investor, the most suitable ETF is different, and investors should select the most suitable ETF based on their own circumstances.

Clarify investment objectives

Different ETFs, based on their different attributes, are suitable for different investment objectives. Some are suitable for savings to achieve long-term stable growth; others are suitable for capturing future growth potential and earning capital gains. In short, investors need to clarify their investment objectives first, to determine whether they are investing for savings or for the purpose of earning appreciation.

Assess risk preference and risk tolerance

Any investment carries risk. Investors who clarify their risk preferences and understand the risks associated with different ETFs can help narrow down their investment decision-making scope. At the same time, investors must clarify their risk tolerance and avoid investing in ETFs that exceed their risk tolerance, especially those with high-risk levels.

Screening and comparison

After matching ETFs with investment objectives, risk preferences, and risk tolerance, investors can compare and screen based on certain attributes of the remaining ETFs, such as fees and holdings. Finally, investors according to their investment style and considering cost-effectiveness, tax efficiency, and other factors, can select the ETFs that suits them best.

How to buy ETFs in Canada?

Purchasing ETFs in Canada is a relatively straightforward process.

Select a Broker and Open an Account

Choose a broker that is professional and can provide quality service for your investment experience, such as moomoo. Then, visit the broker's official website or download the APP and register for an account.

Choose Suitable ETFs

Understand different types of ETFs, review the historical performance, expense ratios, and other related fees of the ETFs you are interested in. Select suitable ETFs based on your investment objectives, risk preferences, and risk tolerance.

Place an Order to Purchase

Transfer funds to your account and place an order to purchase. Please ensure you accurately enter the quantity and amount of the purchase, check the order details, and submit and complete the transaction after verification.

Monitor Your Investments

After the purchase is complete, regularly monitor your investment situation, pay attention to market fluctuations, and avoid unnecessary risks.