Have you ever been the last one to get chosen for any sport during gym class? Well I have, and it's a surreal feeling realizing that, not only you, but everyone else thinks and knows you suck at that sport. So if it's so easy to spot the underachievers in sports, why is it so difficult to choose good simple ETFs?
As harped upon in Lesson 17, an Exchange Traded Fund, or ETF, is a investment that houses a number of stocks, typically focused around one sector or one commonality, that can be traded like a stock. Unlike a mutual fund, an ETF will have its price modified throughout the day (traded like a stock with fluctuating bid and ask prices). ETFs are managed so they do typically contain a very low management fee. ETFs can be sector focused (financials, energy), company size focused (small cap, large cap), fundamental focused (growth, dividend), commodity focused (oil, natural gas), index focused (TSX, S&P, Hang Seng) or any other sort of index or group of equities that share some common quality. There are also ETFs that are leveraged. In other words, it tracks the price movement of a particular area at a multipler (X2, X3). These are of course much more volatile and tend to be more for quick trading purposes when areas of opportunity arise in that particular sector or index. ETFs can also track a market category inversely. This is referred to as a bear ETF where a positive percent change in the category will result in the opposite movement for the ETF (volatility index move sup 1%, ETF ABC moves down 1%). Most ETFs are Bull ETFs, or in other words, track a market category directly.
Don't forget that there are many ETF providers out there as well. These would include Vanguard, Horizon, BMO, to name a few. Each provider has their own management fees. There may be ETFs that track exactly the same thing across each of the providers. For example, Vanguard will have their own ETF that tracks the TSX index, and so will Horizon. There is actually an ETF database website that provides a complete list of ETF issuers.
So imagine all of the combination of ETFs you can possible have... how should one choose ETFs for his or her portfolio?
ETFs are a great way to diversify one's portfolio if there isn't a lot of money to invest. Trying to pick stocks with only a small sum of money can be difficult and cost inefficient due to trading fees. Also, trying to properly diversify your portfolio with a good number of stocks that cover the market can be challenging and time consuming. Purchasing an ETF can instantly diversify yourself since most ETFs track a group of stocks of a particular sector or index. Buying an ETF that tracks the TSX will instantly diversify yourself across the entire market since you are essentially "buying the market". Buying an ETF that tracks the Canadian health care sector will diversify your portfolio across the health care sector.
However, buying too many ETFs can be problematic as well. Buying multiple ETFs in one portfolio can become redundant because of overlapping companies and sectors across each ETF. Purchasing an energy sector ETF, a bull ETF that tracks WTI crude prices, and an ETF that tracks the TSX is not efficient since all three ETFs have overlapping areas (in this case, you essentially own the energy sector or are capturing its price movement in each of the 3 ETFs). Buying multiple ETFs can also inadvertently cause oneself to become over leveraged or too exposed to one sector.
It's important to know what ETF you are buying and what it truly contains inside of it.... what stocks or what market category is it tracking? Is this a good opportunity to own this sector? Which sector has under performed recently or seems undervalued at this point in time? Understanding what and why you are buying an ETF is essential to ensure that one's portfolio remains properly diversified, lean, and effective. For a beginner investor, or simply someone who is a "buy it and forget it" investor, dollar cost averaging into a index ETF will ensure instant diversification in one's portfolio, and will provide consistent compounding returns over a long period of time.
So before impulsively buying any ETF, do your homework and find out which ETF is the best one that works for your portfolio. Because in the end, you don't want to be left choosing the underachiever.