Chapter 1
The (Sort of Still) New Kid on the Block
In This Chapter
Discovering the origins of ETFs
Understanding their role in today’s world of investing
Tallying their phenomenal growth
Looking at the biggest names in ETFs
No doubt, a good number of pinstriped ladies and gentlemen in and around Bay Street exist who froth heavily at the mouth when they hear the words exchange-traded fund. In a world of very pricey investment products and very well paid investment-product salespeople, ETFs are the ultimate killjoys.
Since their arrival on the investment scene in the early 1990s, more than 1,500 ETFs have been created — including about 250 in Canada — and ETF assets have grown faster than those of any other investment product. That’s a good thing. ETFs enable the average investor to avoid shelling out fat commissions or paying layers of ongoing, unnecessary fees. And they’ve saved investors oodles and oodles in taxes.
Hallelujah.
In the Beginning
What do basketball, snowmobiles, insulin, and ETFs have in common? They were all invented in Canada. Yes, you read that correctly. Though our southern neighbours created the stock market, the mutual fund, and many other investment products, the Toronto Stock Exchange developed the first exchange-traded fund. The Toronto 35 Index Participation fund — the first ETF — was listed in March 1990. It tracked the TSE 35 Composite Index, an index made up of the 35 largest and most liquid stocks on the TSX.
As important as the ETF has become, the story behind its development isn’t quite as exciting as, say, the story behind the gas mask or hockey, two other Canadian inventions. As one Toronto Stock Exchange insider explained, “We saw it as a way of making money by generating more trading.” Thus was born the original ETF, best known as TIP. The TSE 35 Composite Index was then the closest thing that we had to America’s Dow Jones Industrial Average index. Some of the companies on the index included Bell Canada, the Royal Bank, and the now-defunct Nortel.
Enter the traders
TIP was an instant success with large institutional stock traders who could now trade an entire index in a flash. The Toronto Stock Exchange got what it wanted — more trading. And the ETF got its start.
TIP has since morphed to track a larger index, the so-called S&P/TSX 60 Index, which — you probably guessed — tracks 60 of Canada’s largest and most liquid companies. The fund also has a different name, the iShares S&P/TSX 60 Index Fund, and it trades under the ticker XIU. It is now managed by BlackRock, Inc., which, upon taking over the iShares lineup of ETFs from Barclays in 2009 (part of a juicy $13.5 billion deal), has come to be the biggest player in ETFs in the world. We introduce you to BlackRock and other ETF suppliers in
Chapter 3. (A completely different BlackRock-managed U.S. ETF now uses the ticker TIP, but that fund has nothing to do with the original TIP; the present-day TIP invests in U.S. Treasury Inflation-Protected Securities.)
Moving south of the border
As much as we may not want to admit it, Canadians have invented a lot of things that Americans have then perfected. Think about the BlackBerry and the iPhone. While the ETF was born in Canada, and was popular, this index-tracking product is as widespread as it is thanks to the U.S. market. The ETF took three years to get to the States, but like most things American, when it launched, it launched big.
The mother of all U.S. ETFs was born on January 22, 1993, and listed on the American Stock Exchange (which, in January 2009, became part of NYSE Euronext). The first U.S.-based ETF was called the S&P Depositary Receipts Trust Series 1, commonly known as the SPDR (or Spider) S&P 500, and it traded (and still does) under the ticker symbol SPY.
The SPDR S&P 500, which tracks the S&P 500 index, an index of the 500 largest U.S. companies, was an instant darling of institutional traders. It has since branched out to become a major holding in the portfolios of many individual and institutional investors — and a favourite of favourites among day traders.
Fulfilling a Dream
ETFs were first embraced by institutions, and they continue to be used, big time, by banks and insurance companies and such. Institutions sometimes buy and hold ETFs, but they’re also constantly buying and selling ETFs and options on ETFs for various purposes, some of which we touch on in Chapter 18. For us noninstitutional types, the creation and expansion of ETFs has allowed for similar juggling (usually a mistake for individuals); but more important, ETFs allow for the construction of portfolios possessing institutional-like sleekness and economy.
Goodbye, ridiculously high mutual fund fees
The average mutual fund investor with a $150,000 portfolio filled with actively managed funds likely spends $3,750 (2.5 percent) or so in annual expenses. By switching to an ETF portfolio, that investor may incur trading costs (because trading ETFs generally costs the same as trading stocks) of perhaps $100 or so to set up the portfolio, and maybe $50 or so a year thereafter. But now his ongoing annual expenses will be about $375 (0.25 percent). That’s a difference, ladies and gentlemen of the jury, of big bucks. We’re looking at an overall yearly savings of $3,375, which is compounded every year the money is invested.
Hello, building blocks for a better portfolio
In terms of diversification, portfolios should include large stocks; small stocks; micro cap stocks; Canadian, U.S., European, and Chinese stocks; intermediate-term bonds; short-term bonds; and real estate investment trusts (REITs) — all held in low-cost ETFs. We discuss diversification and how to use ETFs as building blocks for a class A portfolio in Part II.
Yes, you can use other investment vehicles, such as mutual funds, to create a well-diversified portfolio. But ETFs make diversifying much easier because they tend to track very specific indexes. They are, by and large, much more “pure” investments than mutual funds. An...
