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Busting the myths about ETFs

Are exchange-traded funds passive? Risky? Only for short-term trading? Myths about ETFs can scare investors away. Here’s how to dispel them


Date: April 24, 2017

Exchange-traded funds (ETFs) are some of the fastest-growing investment vehicles on the market today, but many people are still missing out.

The first ETF was launched in the 1990s, yet more than two decades later, myths about these investment vehicles are scaring potential investors away.

“The consequence of not knowing much about ETFs, or believing the myths that are out there, is that people who may benefit financially from these investment instruments are not venturing into the market,” says Krista Matheson, head of ETFs and structured products at Manulife Investments.

So why do these myths persist?

“What’s interesting about ETF myths is that some of them were actually true at one point, but the market has evolved,” explains Ms. Matheson. “I think it’s a relatively new structure and it really is a function of people getting up to speed on the market.”

To help dispel these myths, Ms. Matheson says, “We need to spend a lot more time educating investors about what ETFs are – and what they aren’t, for that matter.”

Here are some common misconceptions about ETFs:

Myth #1: ETFs are passive

“That’s one of the big myths,” says Ms. Matheson. “I think it stems from the fact that this was true at one point and it’s only a recent evolution that ETFs have become more active in nature.”

Originally, ETFs were designed to passively track a specific index and there wasn’t the need for a hands-on approach. Although the majority of ETFs still function this way, there is a growing number that have adopted more active tactics, such as using alternative weighting methods based on factors like volatility or dividends.

“The market has evolved and now you can access all sorts of strategies in an ETF,” adds Ms. Matheson.

Some ETFs do not strictly track a commercial index (like the S&P 500). Instead, they try and outperform that index using a rules-based, active approach.

“It’s true that not all ETFs are passive,” notes Steve Bridge, a money coach from Money Coaches Canada in North Vancouver. “But Canadians need to do their research and choose an appropriate allocation for their risk tolerance and their goals.”

Myth 2: ETFs are riskier than mutual funds

“This is an important myth to quell,” says Ms. Matheson. “There are some ETFs that are riskier, but the majority of ETFs aren’t. For instance, an ETF and a mutual fund that follow the same strategy would have much the same risk.”

It’s when people equate ETFs with stocks that the risk myth really comes to life, says Ms. Matheson. “Anything that trades on an exchange can sometimes be considered riskier, but that’s not always the truth given most ETFs are more broadly diversified than single stocks.”

The perception of ETFs as risky is due to a lack of understanding, says Mr. Bridge.

“You know what’s risky? Not having your investments producing enough return to reach your financial goals – that’s what I consider risky,” he says. “ETFs can be a great way for investors to reach their financial goals.”

Myth 3: It’s hard to know what is in an ETF and how it’s performing

“I’d say it’s almost exactly the opposite,” says Ms. Matheson of this myth. “Many ETFs issuers provide daily transparency into their holdings on their websites.”

Because ETFs trade on an exchange, investors can see the daily performance of their ETFs, she notes. In fact, much of this information can be accessed online. “You can see the price and performance of an ETF anywhere you can see the price of a stock,” says Ms. Matheson.

Myth 4: In ETFs, trading volume equals liquidity

A common misperception is that an ETF’s liquidity is determined by its trading volume, says Ms. Matheson.

“Investors would see any ETF liquidity as a function of the volume of trading on an exchange,” she explains. Called secondary market liquidity, this is the liquidity an investor would see online and is the result of the average daily volume (ADV) of ETF shares traded.

But while ADV can be a good indicator of liquidity for a single stock, it’s not the only gauge for an ETF, says Ms. Matheson. There is also primary liquidity, which is a function of the underlying shares that back the ETF, and how efficient it is to create or redeem shares.

“While ETFs have that secondary market liquidity and that can be an advantage, ETF units can also be created in the primary market too, similar to mutual funds,” she says.

“The process for creating new units for an ETF is a bit different [than mutual funds], but what isn’t different is that like a mutual fund, true liquidity of an ETF comes down to the ability of the fund to purchase its underlying investments.”

Myth 5: ETFs are short-term trading vehicles

“You hear this quite often,” says Ms. Matheson. “I think some investors use ETFs for this purpose, and the fact that they trade on the exchange allow investors to use them for short-term trading. But many ETF strategies are intended to be longer-term investments.”

She notes that because ETFs are typically lower cost, investors can take advantage of lower fees if they hold them over the long term and let compounding work to their advantage.

Also, just because you can use an ETF for the short-term, doesn’t mean you should, adds Mr. Bridge. To do so is exposing oneself to unnecessary risk.

“They absolutely should be for the long term,” he says. “Day trading is risky, and just because ETFs are bought and sold on an exchange doesn’t mean that’s how you should be treating them.”

Sponsored by Manulife

Commentary is for general information purposes only and should not be relied on for specific financial or other advice. Opinions expressed are subject to change based on market and other conditions. Commissions, management fees and expenses all may be associated with exchange traded funds (ETFs). Investment objectives, risks, fees, expenses and other important information are contained in the prospectus, please read it before investing. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

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