Exchange Traded Funds: A Deeper Dive

The simple explanation provided regarding ETFs under our “Investing” tab is not the end of the story. Far from it. There are numerous types of ETFs that can serve different purposes depending on what you are looking to achieve with your investments. So here is a brief look at the different ETFs available.

Equity ETFs

These ETFs are comprised of a group of stocks which will generally track a geographic region or index. They will involve companies with a range of market capitalizations. A sub-category of Equity ETFs include Sector ETFs which will track an industry such as Technology or Industrials.

Bond ETFs

Bond ETFs will include different types of bonds such as government or corporate. Government bonds may be further divided into Federal, Provincial, and Municipal bonds. Because government bonds are backed by future tax revenues, they are considered low risk. Corporate bonds are categorized by investment grade or high yield, often called junk bonds. Rating agencies like Moody’s or Standard & Poor’s will assign credit ratings from Aaa which is the highest all the way down to C which is the worst. Bons ETFs can provide an income stream and diversification benefits to an equity portfolio.

Currency ETFs

As the name suggests these ETFs will invest in one or multiple currencies like the U.S. dollar, Japanese yen, or Euro. The ETFs can achieve this either by being secured with bank deposits or through forward and swap contracts. Currency ETFs can be used to hedge against the decline of an investment or to take advantage of a potential increase. The drawback is these ETFs are sensitive to geopolitical issues and interest rate changes among others.

Commodity ETFs

Commodity ETFs are a great way to invest in a sector that might otherwise be a challenge. Investments can include precious metals, agriculture products, or oil. Access to agriculture products such as wheat or timber is often difficult simply through buying stocks. There are options to buy companies that produce metals such as gold, silver, or copper however it can be very costly to diversify. Commodity ETFs are a great way to hedge against inflation.

Smart Beta or Factor Based ETFs

Most of the major indexes such as the S&P 500 or TSX are market-cap weighted, meaning that the largest companies have the largest weight in the underlying index. Smart beta represents a different way of constructing the index basket. They use rules- based strategies. Common strategies include equal weighting, fundamental weighting, minimum variance, and low volatility. Smart beta ETFs can be broken down into three subcategories: risk-oriented, return-oriented, and other.

Inverse ETFs

Inverse ETFs’ purpose is to gain on the decline of the underlying index. They do this by investing in various derivatives. Because the ETF manager is buying and selling contracts daily and they come with expiration dates inverse ETFs do not make good long term investments. These ETFs can be used for short term hedges if an investor is bearish for the short term but does not want to sell their investments. Purchasing an inverse ETF would also bypass the need to have a margin account if you were planning on short selling.

Leveraged ETFs

Borrowing money is the method in which leveraged ETFs attempt to amplify returns. Traditionally investors would have had to borrow from a line of credit, or margin account to leverage their portfolio, and these are still options. With leveraged ETFs the managers do all the borrowing for you. In order for the leveraged funds to achieve appropriate levels of assets so they can provide their implied leverage, they have to rebalance daily. The problem with that is over time, the compounding of the reset can diverge the performance of the ETF versus the underlying benchmark.