Types of exchange traded funds

ETFs (exchange traded funds) provide a simple way of making investments or trades in areas that would otherwise be out of reach for many retail investors. For example, most retail investors couldn’t feasibly construct a portfolio based on every stock in the S&P/TSX Composite Index. However, there are many ETFs that allow them to participate in that index by letting them, in effect, purchase that basket of stocks through the fund.

There are several main types of ETFs.

Index ETFs

These are ETFs that use a passive investment strategy to track a broad stock market index, like the S&P/ TSX Composite Index, or a particular sector index like the S&P/TSX Capped Financials Index. These are favoured by buy-and-hold investors who want to gain exposure to the long-term performance of an index. Many of these index ETFs pay a monthly or quarterly dividend. Active traders who want to take advantage of swings in an index often trade these ETFs as well.

Portfolio ETFs

Some ETFs invest in a managed portfolio of securities. For example, a balanced portfolio ETF would invest in a basket of fixed income and equity investments. This type of fund allows ETF investors who are seeking convenience to diversify their portfolios.

Fixed-income ETFs

These invest in fixed-income securities either by purchasing a bond index or a basket of bonds, sometimes by using a laddered bond strategy (meaning that bonds are purchased in varying maturities and then reinvested as they mature in order to minimize interest rate risk). Since these ETFs use the interest income from the bonds they hold to pay out a dividend, they offer a tax-efficient way for investors to add a fixed income component to portfolios held in non-registered accounts, since income from bonds does not receive the favourable tax treatment that dividend income does.

Commodity ETFs

This type of ETF tracks the price of a particular commodity, like crude oil or gold. Some commodity ETFs are holding trusts that actually acquire holdings of the physical commodity itself. Other commodity ETFs use futures contracts to track the price of a commodity. Because futures contracts have rollover dates, and commodity prices can be highly volatile, investors who buy these ETFs need to make sure they understand how volatility in the underlying commodity and the futures contracts used by the ETF can affect the value of the fund.

Leveraged ETFs

These are ETFs that use leverage (debt) in order to amplify the gains or losses of a particular index, sector, or commodity price by a stated multiple. They are used by experienced traders who are extremely active. Because they are leveraged, they tend to be far more volatile than their underlying index or commodity and should therefore be approached with caution.

Inverse ETFs

Inverse ETFs simply attempts to perform in the opposite direction of its underlying index, sector or commodity by using short-selling and other methods. For example, an ETF that is an inverse or “bear” ETF for the S&P/TSX Composite Index would rise in value when the index declines, and decline in value when the index rises. These ETFs are often used by traders who want to hedge risk or who wish to take a contrarian position to prevailing market sentiment.