ETFs are Exchange Trade Funds. Generally, they are a pool of assets, which track a published market index. For instance, the IShares S&P/TSX 60 Index ETF (Symbol XIU.TO) invests in the top 60 stocks that make up the S&P/TSX 60 Index published by Standard & Poors. In this particular case, Blackrock Asset Management is the fund manager of this ETF. They purchase the 60 stocks on the Toronto Stock Exchange and sell shares in the ETF to fund it.
The fund manager is not interested in outperforming the index. He is interested in matching the return of the index. Therefore, on any day, you know that if you own this ETF, you own the top 60 stocks on the TSX in the same proportions as defined by the publishers of the index.
ETFs have significantly lower management fees than mutual funds. The fee for managing XIU.TO is 0.04%. If you purchased the Royal Bank Canadian Equity Mutual fund, the fee would be 2.06%. The 5-year return of the RBC fund is 6.65% versus the 9.22% return yielded by XIU.TO. The main difference is the fees that you paid for the privilege of investing in the fund.
ETFs are much cheaper to operate than a traditional mutual fund. ETFs do not raise money by selling to individual investors. They use market specialists to accumulate the underlying assets of an index and the specialists then sell the ETF shares on the Exchange. This significantly reduces the cost of distribution.
Mutual funds have to track your individual ownership of the fund. This leads to expensive accounting and bookkeeping expenses, including year-end tax reporting. ETFs do not do any tracking of individual share ownership. All shares are cleared through the Canadian Depository for Securities and your brokerage firm collects your dividends for you and reports them on your year-end tax forms.
ETFs are a very efficient way to own and trade the stock and bond markets and are a great investment vehicle to provide portfolio diversification. They can be bought and sold through discount brokerage accounts or through an IIROC-registered Investment Dealer.
One should strongly consider moving their mutual fund investments to ETFs and pocketing the 1.5% difference in fees.