When you purchase a stock, also known as a share, you are purchasing ownership in a business and become a shareholder. The more shares you buy the more ownership you have. Stocks can be bought through an exchange such as the Toronto Stock Exchange or the NASDAQ. When you become a shareholder you are granted certain rights and benefits based on the type of share you buy. Below are a few examples.
Typically, you are purchasing a stock because you believe the company will have better prospects in the future. As an owner in the company, you can participate in the growth that well performing businesses experience over time. There are different types of shares such as Common shares or Preferred shares. Both types of shares can be further divided into classes. Based on which Common or Preferred share class you own, you may be afforded the ability to vote at Annual General Meetings. Topics could include Executive compensation, auditing practices, or social issues. The Board of Directors may also approve dividend distributions to shareholders which is another way to generate a profit.
You have the freedom to choose when you buy or sell shares (within exchange operational hours), which stocks you purchase, and how many you buy of that business. Stock prices fluctuate by the second. In the short term prices are determined by supply and demand but over the long haul prices align with company fundamentals and cash flow. The risk with stocks is that you can lose some or all of the value of your investment if the company performs poorly or fails completely and cannot pay it’s obligations. You can purchase stocks and ETFs through a self-directed investment account or a licensed broker.
“Diversification is the only free lunch” – Harry Markowitz
So what are ETFs? Exchange Traded Funds are pooled funds from numerous investors managed by an asset management team. an ETF is comprised of different securities such as stocks, bonds and commodities that are bundled together in one investment. Like stocks they can be purchased through a self-directed account or a broker and trade on an exchange like the Canadian Stock Exchange or New York Stock Exchange.
Since ETFs hold a variety of financial instruments the holder can achieve instant diversification whereas getting a sufficient mix with stocks would take varying multiple shares and could be costly. Like stocks ETFs’ price changes constantly however one difference is a buyer owns units instead of shares. This is because ETFs are set up as trusts.
A trust structure allows for much smaller price points for investors, anywhere from $10-$80 for example. With stocks some prices can be north of $1,000 which is prohibitive if somebody is just starting out. Rather than mainly supply and demand ETFs’ prices are also based on net asset value, profit spread, and the market-makers bid-ask spread.
Market-makers post bid and ask values on an exchange and assist with liquidity to ensure competitive pricing. ETFs also create profit through capital gain and dividends but may also offer interest income as well depending on the type of fund. ETFs can be either passively or actively managed. To purchase stocks and ETFs generally there will be commissions involved depending on the method of purchase.
There are some differences between the two securities. ETFs are constructed by asset managers and therefore do charge a management fee. Management fees can start as low as 0.02% but ultimately depend on the type of ETF. Another drawback is because the asset managers are the ones deciding when to buy, sell, and send distributions, the unit holder does not have taxation flexibility if the ETF is held in a non-registered account.
Along with regular market risk, specific risks to ETFs include tracking error, liquidity risks, and leverage risk. ETFs are designed to replicate to the best of its ability the return of a benchmark. The challenge is there are transaction costs, rebalancing issues, and weighting measurements that may diverge the benchmark and ETF returns.
The liquidity is also at the mercy of the market-maker’s ability to provide information and match buyers with sellers. Less liquid ETFs will have a larger bid-ask spread which translates to higher costs. Some ETFs are designed to return 2x or 3x a given benchmark. Combining leverage with the fact that ETFs are settled daily, the desired return multiple can stray from the target. Want to learn about specific ETFs? Find our Investment Insights through any of our Membership Plans!