How Exchange-Traded Funds (ETFs) work (2024)

How do ETFs make money for investors?

ETFs are funds traded on a stock exchange. Their prices will fluctuate throughout the day, like stocks do.

You can make money from ETFs by trading them. And some ETFs pay out the money the ETF makes to investors. These payments are called distributions. For example, you may receive:

  • Interest distributions if the ETF invests in bonds.
  • Dividend distributions if the ETF invests in stocks that pay dividends.
  • Capital gains distributions if the ETF sells an investment for more than it paid.

Unlike many mutual funds, ETFs do not reinvest your cash distributions in more units or shares. What happens with your distributions is:

1. The cash stays in your account until you tell your investment firm how you want to invest it. You may have to pay a sales commission on what you buy.

2. Your investment firm may offer a program to automatically buy more ETF units or shares for you. You likely won’t pay a sales commission on these automatic purchases.

Watch our video: What is an ETF?

Why do some investors choose ETFs?

There are several reasons why you might want to invest in an ETF including:

1. Diversification

When you buy a share or unit of an ETF, you’re investing in a portfolio that holds several different stocks or other investments. This diversification may help smooth out the ups and downs of investing. You can also spread your money among ETFs that cover various investments, such as bonds or commodities. This allows you to further diversify.

2. Passive management

Most ETFs are designed to track an index, such as the S&P/TSX 60. This is called passive investing. Passive investing tends to cost the consumer less compared to active investing. That’s when a portfolio manager actively buys and sells securities to try to outperform the market. There are advantages to active strategies, but passive strategies can outperform active investing based on cost savings alone.

3. Transparency

Most ETFs publish their holdings every day. You can see what investments your ETF holds, their relative weighting in the fund and if the fund has changed its position in any particular investment. This transparency can help you tell if an ETF is meeting its investment objectives. You can usually find out what investments an ETF holds, and their relative weighting in the ETF, on a more frequent basis than for mutual funds, which only disclose their holdings periodically.

4. Ease of buying and selling

You can buy and sell ETFs from an investment firm or online brokerage at any time when the stock exchange is open, at the current market price at the time of the transaction. Like stocks, ETFs are traded throughout the day at the current market price. You’ll usually pay a commission when you buy or sell an ETF.

Unlike a mutual fund, which is only priced at the end of the trading day, ETFs are traded throughout the day at the current market price. You can find the current market price for ETFs at any time, while mutual fund prices are usually only available once daily.

5. Low cost to own

You may pay less to own an ETF than a mutual fund, depending on the fund you buy. Index ETFs, for example, simply track an index, so the portfolio manager doesn’t actively manage the fund, which can mean a lower management expense ratio (MER).

Actively managed ETFs and leveraged ETFs have higher MERs than index ETFs, but may have lower MERs than actively managed mutual funds.

What kind of fees do ETFs have?

Most ETFs have fees that are lower than a typical mutual fund but cost more compared to owning a stock. There are 2 main types of ETF fees:

1. Trading commissions – Like a stock, you will usually pay a commission to the investment firm every time you buy or sell an ETF. Consider how these costs will affect your returns if you’re planning to make frequent purchases or trade often.

2. Management fees and operating expenses – Like a mutual fund, ETFs pay management fees and operating expenses. This is called the management expense ratio (or MER). MERs for ETFs are usually lower than those for mutual funds in the same class. They are paid by the fund and are expressed as an annual percentage of the total value of the fund. While you don’t pay these expenses directly, they affect you because they reduce the fund’s returns. This can add up over time.

You pay commissions to buy and sell ETFs, so if you plan to trade frequently, these costs will impact your return. You will also pay management expenses regardless of how the fund performs, even if the fund has negative returns.

Before you invest, read the ETF’s prospectus or its summary disclosure document to understand the fees. You can find these documents on the ETF manager’s website.

Visit our ETF facts interactive sample to see the information you should know before you invest. You can compare fees and performance online at websites like Globefund and Morningstar.

What kind of taxes will you pay on ETF investments?

When you invest in ETFs, you’ll pay tax on:

  • any capital gains you make from an ETF when you sell it.
  • any distributions you receive from the ETF.

If you hold an ETF inside a tax-sheltered account such as an RRSP or a RRIF, you won’t pay tax until you take the money out. With a TFSA, you won’t pay any tax while it’s in a plan or when you take it out. Learn more about how investments are taxed.

Because ETFs are traded on stock exchanges, this means their performance will rise and fall along with the stock market. Learn more about how the stock market works.

What are the risks of investing in ETFs?

The level of risk and return of a specific ETF depends on the type of fund and what it invests in. Risks can include:

1. The trading price of units or shares can vary – Units or shares may trade in the market at a premium or discount to their net asset value (NAV) because of market supply and demand. The premiums and discounts for specific ETFs vary, depending on the type of ETF and time period.

2. Concentration can lead to volatility – If an ETF is heavily invested in only a few investments or types of investments, it may be more volatile over short periods of time than a more broadly diversified ETF.

3. There may not be an active market – Although an ETF may be listed on an exchange, there is no guarantee that investors will buy its units or shares. That means you may not be able to sell your ETF when you want to. An active market may not develop or be sustained for the ETF.

4. Some have no benchmark – Some ETFs are indexed, which means it is easier to track their performance against a benchmark. However, this is not true of all ETFs. Active ETFs, for example, may not be designed to track an index so it’s hard to compare performance over time.

Each type of ETF has its own set of risks. Learn more about the risks of different types of ETFs.

How Exchange-Traded Funds (ETFs) work (2024)

FAQs

How Exchange-Traded Funds (ETFs) work? ›

An exchange-traded fund (ETF) is a basket of securities that trades on an exchange just like a stock does. ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds, which only trade once a day after the market closes.

What is the difference between an ETF and an exchange traded fund? ›

ETFs have lower expense ratios. Mutual funds have higher management fees. ETFs are passively managed, mirroring a particular index, making them less risky and transparent. Mutual funds are actively managed, with fund managers investing based on analysis and market outlook.

How do you make money with exchange-traded funds ETFs? ›

Most ETF income is generated by the fund's underlying holdings. Typically, that means dividends from stocks or interest (coupons) from bonds. Dividends: These are a portion of the company's earnings paid out in cash or shares to stockholders on a per-share basis, sometimes to attract investors to buy the stock.

How are shares of exchange-traded funds ETFs bought and sold? ›

An exchange-traded fund (ETF) is a pooled investment vehicle with shares that trade intraday on stock exchanges at a market-determined price. Investors may buy or sell ETF shares through a broker or in a brokerage account, just as they would the shares of any publicly traded company.

How do ETFs work understanding exchange-traded funds? ›

ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.

What are three disadvantages to owning an ETF over a mutual fund? ›

Disadvantages of ETFs
  • Trading fees. Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ...
  • Operating expenses. ...
  • Low trading volume. ...
  • Tracking errors. ...
  • The possibility of less diversification. ...
  • Hidden risks. ...
  • Lack of liquidity. ...
  • Capital gains distributions.

What are three advantages of investing in exchange-traded funds ETFs? ›

ETFs can offer lower operating costs than traditional open-end funds, flexible trading, greater transparency, and better tax efficiency in taxable accounts.

Are ETFs good for beginners? ›

The low investment threshold for most ETFs makes it easy for a beginner to implement a basic asset allocation strategy that matches their investment time horizon and risk tolerance. For example, young investors might be 100% invested in equity ETFs when they are in their 20s.

How do you get paid from an ETF? ›

ETFs pay dividends earned from the underlying stocks held in the ETF. An ETF that receives dividends must pay them to investors in cash or additional shares of the ETF. Dividends may be taxed at the long-term capital gains rate or the investor's ordinary income tax rate.

Can you cash out ETFs? ›

ETF trading generally occurs in-kind, meaning they are not redeemed for cash. Mutual fund shares can be redeemed for money at the fund's net asset value for that day. Stocks are bought and sold using cash.

When you buy an ETF do you own the shares? ›

Exchange-traded funds work like this: The fund provider owns the underlying assets, designs a fund to track their performance and then sells shares in that fund to investors. Shareholders own a portion of an ETF, but they don't own the underlying assets in the fund.

What happens to the money in ETF? ›

ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.

When you buy an ETF where does the money go? ›

An exchange-traded fund, or ETF, allows investors to buy many stocks or bonds at once. Investors buy shares of ETFs, and the money is used to invest according to a certain objective. For example, if you buy an S&P 500 ETF, your money will be invested in the 500 companies in that index.

How do you profit from ETF? ›

Traders and investors can make money from an ETF by selling it at a higher price than what they bought it for. Investors could also receive dividends if they own an ETF that tracks dividend stocks. ETF providers make money mainly from the expense ratio of the funds they manage, as well as through transaction costs.

Should I just put my money in ETF? ›

For most individual investors, ETFs represent an ideal type of asset with which to build a diversified portfolio. In addition, ETFs tend to have much lower expense ratios compared to actively managed funds, can be more tax-efficient, and offer the option to immediately reinvest dividends.

How much of your money should be in ETFs? ›

You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all. Consider the two funds below.

Is an exchange fund the same as an ETF? ›

Exchange funds provide investors with an easy way to diversify their holdings while deferring taxes from capital gains. Exchange funds should not be confused with exchange traded funds (ETFs), which are mutual fund-like securities that trade on stock exchanges.

What is the difference between ETF and fund of funds? ›

FoFs are actively managed funds while ETFs are considered to be passively managed funds. Hence the cost or the expense ratio is higher in the case of FoFs as compared to ETFs.

Is S&P 500 a mutual fund or ETF? ›

An index fund is a type of mutual fund that tracks a particular market index: the S&P 500, Russell 2000, or MSCI EAFE (hence the name). Because there's no original strategy, not much active management is required and so index funds have a lower cost structure than typical mutual funds.

What are 2 key differences between ETFs and mutual funds? ›

While they can be actively or passively managed by fund managers, most ETFs are passive investments pegged to the performance of a particular index. Mutual funds come in both active and indexed varieties, but most are actively managed. Active mutual funds are managed by fund managers.

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