5 reasons to use exchange traded funds

Exchange-traded funds (ETFs) are gaining in popularity as an alternative to stock picking (stocks and bonds) and mutual funds. And for good reason; they combine the advantages of mutual funds (diversification and institutional-style management) and publicly traded securities (liquidity and transparency).

Here are 5 good reasons to use ETFs to manage your portfolio.

The assurance of harvesting market returns

Index ETFs (those that passively replicate stock market indexes such as the S&P/TSX Composite for example) ensure that their holders achieve the same return as the stock market index, dividends included; no surprise there. In 2016, for example, while the "Canadian stock market" (measured by the S&P/TSX Composite index of the 300 largest listed companies) returned 21.08%, the 2 main ETFs that replicate this index, BMO's ZCN and Blackrock's XIC, returned 20.99% and 21.01% respectively. Vanguard's VCN which replicates a slightly different index (the FTSE Canada All Cap Index) made a return of 21.46% in 2016.

The following table shows the after fee performance of XIC, the oldest ETF that replicates the S&P/TSX Composite, launched in 2001. The difference between XIC's performance and that of the index is primarily due to fees (0.07% in 2016 and 0.11% on average since launch

Of course, the Canadian stock market will not provide a 21% return every year. There will be good years and bad years. Some will be downright horrible, like 2008! Over the long term, however, the stock market should offer a return of 7% annually, which is enough to build a balanced portfolio to reach your financial goals.

Lower fees = higher returns

The stock market is a "zero-sum game": for every investor who does better than the market return, another must do worse. It's normal, everyone can't be bigger than the average! Fund managers therefore achieve on average a return similar to that of the stock market, before fees. The best way to increase your return is to lower your fees. At about 0.06% in fees for ETFs like VCN, XIC and ZCN, it's hard to imagine a less expensive way to ensure that you're getting the return of the equity market, especially when compared to the more than 2% in fees on average for a mutual fund. Such a reduction in fees has a very significant impact on the growth of your portfolio and on your retirement income. See How to increase your retirement income by 35%.

Tax efficiency

Like mutual funds, ETFs are required to make year-end capital gains distributions to their holders on the sale of securities held by the ETF. These capital gains distributions are taxable to the holders. However, index ETFs are much less active in trading their holdings and therefore distribute much less capital gains annually, thus deferring the tax, so unlike mutual funds that actively trade to try to "beat the market," index ETFs generally have no reason to sell their holdings. In addition, when a mutual fund owner redeems his or her units, the fund must sell securities in the market to obtain the cash needed to redeem, triggering capital gains. In the case of an ETF, the holder does not redeem his or her units but simply sells them in the market, which has no impact on the remaining holders of the ETF.

Liquidity

Index ETFs are among the most actively traded securities on the exchange. As a result, they offer high liquidity. They are often even more liquid and easier to trade than the securities that make up the index they replicate. This is the case, for example, with corporate bond ETFs, which an investor can easily buy on the stock market, whereas it would be very difficult (and very expensive) to buy corporate bonds directly.

Transparency

Finally, ETFs offer total transparency. The complete list of securities they hold can be consulted at any time on their website. Mutual funds, on the other hand, are only required to make their portfolios public on a quarterly basis and with a one-month delay.