Types of exchange traded funds (ETFs)

ETFs have become an incredibly popular investment product over the past five years, although they’ve existed in Canada since 1990. They offer a low-cost way to invest, providing access to a diversified portfolio of stocks or bonds in a single investment that trades just like a stock. Whether the chicken came first or the egg, as the number and types of ETFs have grown, the assets flowing into ETFs have also grown rapidly. It seems that more Canadians are considering ETFs for their portfolios, and financial companies are responding with the creation of more and more ETFs.

ETF types can be broadly categorized by asset class, such as stock ETFs and bond ETFs. You might start by choosing an ETF for broad asset class exposure, but also consider some of the more specialized ETFs to target a particular sub-class or sub-category within the broad class. Let’s explore some of the ETF types that are currently available for Canadian investors.

Index ETFs that aim to match the performance of well-known broad indexes are a popular choice when building a basic ETF portfolio. These ETFs can provide across-the-board exposure to the traditional mainstay portfolio building blocks: stocks and bonds. You can find an ETF to replicate the performance of almost every well-known broad index. Owning an ETF that aims to replicate index performance can give you confidence that your returns will approximate the broad index return, less management fees. This can be reassuring since broad indexes are often used as benchmarks by mutual funds and asset managers, and many asset managers will underperform their benchmarks.

Thematic ETFs

There are many ways to slice and dice the investment universe, but one way to organize your approach is to focus on an investing or economic trend or theme. For example, over the past 10 years there’s been growing interest in companies that are socially or environmentally responsible. This gave rise to the popularity of Environmental, Social and Governance (ESG) investing criteria and many ETFs that spotlight this theme have been created. Other themes revolve around new technologies or social changes. There are ETFs that target companies connected to artificial intelligence or the drone economy. There are even ETFs that target companies involved in cancer drug research and development using immunotherapy. New investing themes are popping up all the time.

Sector ETFS

You might distinguish a sector ETF from a thematic ETF by the fact that industry sectors are well established and often have an official financial industry classification. Some of the most popular and well-known industry sectors are financials, consumer discretionary goods and information technology. You can imagine that many current sector classifications grew out of what was once a new investing theme. Information technology is an example of an advancement that took shape in the 1970s and 1980s and later became a bona fide industry sector. Some of today’s early-stage investing themes may eventually become their own industry sectors.

Regional ETFs

Regional ETFs let you target specific economic regions, such as Europe, Asia or Latin America, while also diversifying broadly across industries within those regions. Regional ETFs also include ETFs dedicated to alternate ways of classifying world regions, such as emerging country ETFs versus developed country ETFs.

Country ETFs

Country ETFs typically allow you to invest in a single country without worrying about currency conversions or time differences when buying and selling. Depending on which foreign ETF you choose, you may still be exposed to fluctuations in the foreign currency versus your home currency. Check whether your selected ETF is hedging the foreign currency or not — sometimes both types of ETF are available, and you can choose between them. These ETFs often use the components of a well-known country benchmark index to define the ETF’s holdings.

Smart Beta ETFs and equity strategy ETFs

Smart Beta ETFs track indices that use stock selection and weighting criteria that are different from typical equity benchmark indexes, where market capitalization typically determines stock weighting. Some Smart Beta ETFs may use dividend yield, volatility or other indicators for security selection. The strategy is looking to identify securities that will outperform the broad market in the future. Other ETF equity strategies, such as value ETFs or growth ETFs, also focus on a subset of the broad market and provide exposure to groups of stocks that may do well under different economic conditions.

You can approach the bond market simply, perhaps by investing in an aggregate bond ETF, or choose a more targeted bond ETF. A broad choice, like an aggregate bond fund, will typically hold both government and corporate bonds, often limited to investment grade only, with medium to longer term maturities — 5 years and up. Aggregate bond ETFs are also available for just corporate bonds or just government bonds, as well as ETFs that target particular maturities such as 1-year, 2-year or 5-year bonds. Corporate bond ETFs may focus on a particular level of risk with holdings concentrated in just one rating tier, from highly rated bonds to junk bonds, or mix all rating levels in one fund.

A leveraged ETF is generally looking to deliver a multiple of the daily performance of the index or benchmark that it tracks. An inverse ETF generally attempts to deliver the inverse of the daily performance of the index or benchmark that it tracks. Some ETFs are both inverse and leveraged, meaning that they seek a return that is a multiple of the inverse performance of the underlying index. Inverse ETFs are often marketed as a way for investors to profit from, or at least hedge their exposure to, downward-moving markets. The mechanics of these ETFs can be much more complicated than regular ETFs and they’re often used as short-term trading vehicles, with a substantially higher risk than traditional ETFs. The performance of leveraged and inverse ETFs that reset daily can differ significantly from the performance of their underlying index or benchmark over longer periods of time.

Commodity ETFs let you invest in commodities and participate in their performance. There are ETFs available to track a wide range of products, from agricultural commodities to precious and industrial metals to oil and gas, or a mix of many commodity types. The performance of commodities is somewhat complicated to access through a stock holding, since the stock’s performance depends on both the company outlook and the performance of the commodity itself. While a commodity ETF may hold commodity stocks, it can also invest in the commodity using futures and derivative contracts. These ETFs can be especially interesting for investors during inflationary periods, as commodity prices are often correlated to, and may also contribute to, the overall inflationary outlook.

Currency ETFs can provide exposure to a single currency or a basket of currencies. A currency ETF will typically use futures and derivative products to achieve its return. Individual investors can use these ETFs to speculate in a particular currency, without the need to dive into the world of FX contracts and foreign exchange accounts. In addition to speculation, currency ETFs could be used to hedge the currency risk of your existing portfolio holdings.

Real estate ETFs can be used to gain exposure to a diverse portfolio of real estate assets. The ETF typically invests in real estate investment trusts (REITS) or mirrors a REIT Index performance. REITs may hold a particular type of real estate, such as shopping malls or condominiums, and may target a particular geographic area. Like commodity ETFs, real estate ETFs may be interesting during inflationary periods due to their relationship to consumer price levels. As always, individuals should do their homework to determine whether real estate ETFs or any of the ETFs described are right for you.

Derivatives are sometimes used by ETF managers to ensure the most accurate replication of the target index or to manage fund inflows or outflows. Many ETFs are available in both currency hedged and non-currency hedged versions. This can provide you with more flexibility and allow you to choose the version that best suits your overall investing plan.