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December 8, 2021

What to Know Before you Invest in ETFs

Exchange Traded Funds, more commonly referred to as ETFs, are a popular alternative to traditional investment vehicles such as individual stock trading and mutual funds. An ETF is a passively-managed collection of stocks or bonds that may be purchased for one price. ETFs are relatively new in the investment world but have made a serious impact. There are almost 800 ETFs in Canada with over $160 Billion of Canadian assets invested*.

As a relatively new investment option, there are still many misconceptions about ETFs and how they work. Here are some of the most common myths about ETFs.

Myth #1: ETFs Are the Same as Stocks

While it’s true that ETFs and stocks are both traded on exchanges, they are very different investment vehicles. When you purchase a stock, you are purchasing shares of a single company and the success of your investment will depend on the rise/fall of that one stock. When you purchase an ETF, you are purchasing a basket of securities that work together to determine the value of your investment. ETFs offer much more diversification than a single stock. At Cumberland, we typically invest in a portfolio of carefully researched stocks, which provides investors with good diversification but also allows for stock selections (thereby avoiding regional, sector or stock exposures that may carry undesired risks). We may utilize ETFs in portfolios where they are the most efficient way to get specific exposures, as described in greater detail below.

Myth #2: ETFs Have Liquidity Issues

Perhaps one of the biggest concerns investors have when it comes to ETFs is their liquidity. ETFs have arguably developed an unfair reputation of having low liquidity. An ETF’s liquidity is made up of two components: the volume of ETF units traded on an exchange and the liquidity of the basket of securities that make up the ETF’s portfolio. Knowing how an ETF’s liquidity is determined will help you evaluate it appropriately and make a selection with sufficient trading volume of its units and its underlying holdings so you can comfortably buy and sell them without any significant issues or costs.

Myth #3: ETFs Only Offer Broad Exposure

Many ETFs offer broad market exposure, such as index funds that follow an entire index, like the S&P 500. These were some of the first types of ETFs available to investors and still make up a large part of the ETF market. However, ETF markets have evolved in the past number of years to offer more targeted investment options. Investors now have access to ETFs that focus on specific sectors (e.g. energy, infrastructure), asset classes (e.g. high yield bonds), and geographic locations (e.g. emerging markets). At Cumberland, we selectively use these more narrowly-focused ETFs in cases where it is the most efficient method of gaining a specific portfolio exposure.

Myth #4: ETFs are All Low Cost

ETFs came into the spotlight as a low-cost alternative to traditional mutual funds. It is true that some ETFs offer low-cost index tracking solutions, although many of them have hidden fees and costs embedded in them. While the cost of investing should be a consideration for investors, it should not be the most important driver. Performance, risk tolerance, appropriateness of the ETF, liquidity, and the given ETF’s role in overall portfolio construction should always be leading priorities.

Myth #5: ETFs Can Replace Active Portfolio Management

Passive ETFs are sometimes promoted as a substitute for active portfolio management. In reality, there are significant differences and trade-offs. To take just one example, Shopify recently became one of the most valuable stocks in the Canadian index, which means that many ETF investors ended up with it as their largest holding by default. In contrast, an active manager will judge the merits of a stock like Shopify and decide whether it deserves such a heavy portfolio weighting, or whether it’s better to take a more nuanced approach and limit the risk of a potentially large drawdown at given points in time.

At Cumberland, we believe that ETFs work best when integrated into a professionally-managed investment portfolio. This way, they can be used in the instances where they are most likely to align with your specific investment objectives, taking into account all the myths and realities surrounding diversification, liquidity, portfolio exposures, costs and active portfolio management.

We welcome the opportunity to review ETFs with you alongside our investment philosophy and process. Please reach out to us by calling 1-800-929-8296 or emailing contact@cpwm.ca, and one of our Portfolio Managers will be in touch soon.

  • Advisor Research Group