ETF Basics – Using ETFs in a Simple Portfolio

How ETFs work in practice

An exchange-traded fund is a basket of investments (like stocks or bonds) that you buy and sell on an exchange, just like an individual stock. When you buy one share of an ETF, you get exposure to all of the holdings inside that fund.

Many ETFs track an underlying index – for example, a broad Canadian stock index or a global stock index. The ETF’s job is simply to match the index as closely as possible, before fees.

For most long-term investors, the appeal of ETFs is simple:

• Broad diversification in a single trade
• Typically lower costs than many mutual funds
• Transparency – you can see what the fund holds

Index vs. active ETFs

Broadly speaking, ETFs fall into two camps:

• Index ETFs aim to track a specific benchmark as closely as possible.
• Active ETFs give a manager flexibility to pick securities or adjust exposures in an effort to beat a benchmark.

For investors building a simple, rules-based plan – especially those following ideas from 3-fund portfolios or asset allocation – low-cost index ETFs are often a natural fit.

Why ETF costs matter so much

ETF costs are usually expressed as an annual expense ratio or management expense ratio (MER). This is charged as a small percentage of the assets you hold in the fund each year.

A difference of one or two percentage points may not sound like much, but over 20–30 years it can translate into tens or hundreds of thousands of dollars. You can see this for yourself with our Fee Impact Calculator.

Costs are one of the few things investors can control directly, so it usually makes sense to keep them low where possible, especially in core, long-term holdings.

ETFs as building blocks

Many investors use ETFs as the basic building blocks in their portfolios. A simple approach might include:

• One broad domestic stock ETF
• One broad international stock ETF
• One bond ETF

This is the essence of the 3-fund portfolio idea. The exact tickers you choose matter less than keeping costs low, diversification broad and your asset allocation appropriate for your timeframe and risk tolerance.

Which accounts to hold ETFs in

In Canada, investors often hold ETFs inside registered accounts like TFSAs and RRSPs, or in taxable accounts. Each has different tax treatment, withdrawal rules and contribution limits, as covered in TFSA vs RRSP.

The “best” location for a given ETF depends on factors such as withholding taxes on dividends, your current and future tax brackets, and how likely you are to need the money before retirement.