Debunking the Myths Associated with Exchange-Traded Funds
Many potential investors are just as misinformed as they are informed about ETFs. The following helps to dispel some of the most commonly held ETF misconceptions.
Myth #1: Trading volume dictates an ETF's liquidity
False: An ETF’s liquidity is not established by its trading volume but by its underlying holdings. At minimum, an ETF or mutual fund will be as liquid as its underlying holdings.
ETFs are open-ended investment vehicles (similar to open-ended mutual funds). They can issue new shares or withdraw existing shares in the market to meet investor supply and demand. This helps explain why metrics like assets under management (AUM) or trading volume are not helpful in estimating the liquidity of an ETF.
An ETF that invests in large companies will have relatively higher liquidity as these stocks trade millions of shares daily. By contrast, ETFs that invest in smaller or less liquid stocks may experience relatively lower liquidity, which can increase price swings, similar to a mutual fund structure.
Investors and advisors should evaluate an ETF’s underlying holdings to determine liquidity, not its trading volume or AUM. If there is no liquidity concern with a mutual fund that invests in similar securities as an ETF, there should be no concern with regards to the liquidity of an ETF.
Myth #2: ETFs with higher trading volume are better investment options than ETFs with lower trading volume
False: An investor or advisor should evaluate an ETF’s merit based on its underlying holdings and investment objective rather than trading volume. The popularity of ETFs in Canada has led to a proliferation of new options in the industry. As a result, many ETFs do in fact have low average daily trading volume. However, as previously mentioned, trading volume is not indicative of an ETF’s liquidity or viability, and many of these securities can act as large diversified core solutions in an investor’s portfolio.
Before you choose any kind of security, including ETFs, it’s important to understand the role they will play in your overall investment strategy.
Myth #3: ETFs are more risky than mutual funds
False: ETFs have similar characteristics to mutual funds but trade on an exchange. There is nothing inherently different about an ETF that would expose investors to increased risk relative to a mutual fund. The most significant influences on any ETF or mutual fund’s risk profile are the risks associated with investing in the financial markets, the type of individual securities that the fund invests in, and the investment style and strategy of the fund.
Myth #4: ETFs are not suited for long-term investors
False: Like mutual funds, exchange-traded funds are effective portfolio construction tools. While ETFs may be used by active investors as short-term trading vehicles, they can also be used effectively as buy-and-hold investments for long-term investors. Whereas one investor may purchase a particular ETF to hedge, another may buy the same ETF for a completely different strategy, such as to grow capital.
The product design and versatility of ETFs allow investors with similar or different investment objectives to own the same product and still accomplish their respective goals.
Myth #5: ETFs are so simple that you don’t need professional advice to invest in them
False: The growth of the ETF industry has resulted in greater choices for investors. But with over 1000 ETFs now available in Canada, it has become even more difficult to pick the right solution for you. Investors should conduct proper due diligence and work with an advisor, where possible, to design an appropriate asset allocation strategy, then choose the individual investments that can help them meet their objectives, whether they be mutual funds or ETFs.
As investors’ needs continue to become increasingly complex, education to simplify the products and enhance the understanding of ETFs is crucial. Visit www.firstasset.com or speak to your financial advisor about how ETFs can add value to your portfolio and help you achieve your financial goals.