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More and more research and statistics are coming out in favour of index-investing. You may have heard the term or its similar terminologies such as Exchange-Traded Funds (ETFs), or passive investing.
If you haven’t, index-investing is a no-frill, cut-to-the-chase form of investing. It’s a strategy that seeks to replicate market returns, not beat them. This idea may confuse you and likely goes against your previous intuitions about investing. Even though you aren’t beating the market with index-investing, you aren’t trailing the market either. If you didn’t know, beating the market is challenging (and not recommended).
Wall St. and Bay St. money managers spend hours and thousands of dollars on research attempting to beat the market, and often still come up short. This is something you wouldn’t realize from watching popular finance movies and television such as The Big Short, The Wolf of Wall Street, or Billions. In these shows, the money managers anticipate market movements and move their money accordingly. Either by anticipating a market crash and exiting the market or investing in worthless stocks hoping to quadruple their money in a short amount of time. This anticipation is what we call an ‘active’ strategy and is the complete opposite of index-investing or a passive approach.
With index-investing, there is no anticipation whatsoever. When you have money to invest, you enter the market, earn the return of the market, and exit when you need to use said money. Straightforward and clear-cut. In addition to the ease and lack of emotional attachment involved, index-investing is also cheap. Crazy cheap when compared to other strategies.
You can achieve index-investing through purchasing ETFs on a stock exchange. When I mentioned that passive strategies replicate ‘market returns,’ they imitate or copy the investments of a particular index such as the S&P 500 in the United States. This index includes 500 of the U.S’s largest companies and a relatively comprehensive picture of the market. The index that each ETF attempts to replicate is called their ‘benchmark’. In addition to the S&P 500, there are hundreds of other indices that include companies and countries from all over the world.
If you wanted to achieve the same returns as the U.S. market, you could purchase an ETF that has the S&P 500 as its benchmark. Three ETFs with these characteristics that are available to purchase on the Toronto Stock Exchange (TSX) are the SPDR® S&P 500 ETF (SPY), the iShares Core S&P 500 ETF (IVV), and the Vanguard S&P 500 ETF (VOO). The cost to purchase and hold these investments is called the ‘Management Expense Ratio (MER)’ and represents a percentage of the amount of money you have invested. The MER on these three ETFs is 0.09%, 0.04% and 0.04%. In comparison, actively managed funds may have expense ratios upward of 2.0%.
It’s essential to understand the basic terminology and analysis to make a confident decision when investing. Online resources will make your research much more manageable. Since ETFs trade on a stock exchange, most stock tracking websites such as Yahoo Finance, Morningstar, or The Motley Fool will also include ETF information. The company that holds your brokerage account, such as TD Bank or Questrade, will also have information on ETFs for you to use.
When analyzing an ETF, you can find important information on an up-to-date fact sheet. A fact sheet is a concise, four-page summary of the fund. In Canada, new buyers must receive fact sheets within two days of purchase; however, you can also find fact sheets on the issuer’s website before purchase. You can find a sample fact sheet here. While I was trying to learn more about ETFs, these fact sheets were confusing and made the experience more intimidating. What did all of these numbers, abbreviations and graphs mean? And I’ve been reading financial documents for a while.
After doing the decoding for myself, I felt that these terms were a lot less scary than they initially seemed. I felt that other potential investors would feel the same if someone broke it down in plain English. From my research as a new ETF investor, below are the things that I think are most important and least important when doing your analysis.
Like I previously mentioned, all ETFs have an underlying index. This is a critical factor in choosing an ETF. Often, a single index will have multiple ETFs, and in that case, you can differentiate them to some extent (minor fee differences, additional liquidity, etc.). However, you will likely achieve similar results. Comparing ETFs based on cost doesn’t mean anything if one ETF follows small companies in Brazil, and the other follows the largest companies in the U.S.
Liquidity means your ability to buy and sell an investment quickly and without a significant change to the price. Another way of thinking about liquidity is the number of buyers and sellers in the market. When there is a high amount of liquidity, there are many buyers and sellers, and trading happens smoothly. On the other hand, when there is low liquidity, you’ll either have to settle on timeliness or price. Generally, the higher the liquidity, the less risky the investment.
With any investment, including ETFs, you’ll want to analyze liquidity. An easy way to do this is by looking at the ‘spread.’ The spread is the difference between the bid and ask prices of an investment. The bid is the highest price a buyer is willing to buy, and the ask is the lowest price that a seller is willing to sell. The bid and ask prices can be found on any stock tracking site such as Yahoo Finance. The smaller the spread, the higher the liquidity. The dollar value may not appear significant, but it is. A small spread could be a few cents, versus a large spread that could be tens of cents.
Tracking error refers to the difference between the return of the fund’s benchmark and that of its own. Since you invest in ETFs to earn the market return, you want to make sure that that’s what you’re getting. The process of replicating the market return has to do with the management team and the specific index. A large tracking error could indicate poorly executed trades on the management team’s part, or it could result from following a very obscure index.
If you have chosen an index to follow, comparing the various ETF options based on tracking error is an excellent way to narrow down your search. You can see the tracking error on a fund fact sheet. They will often disclose performance numbers for both your ETF and the benchmark it follows over various periods.
The price of an ETF is disclosed in the ‘Management Expense Ratio’ or MER on the fact sheet. This is the annual fee, much like a subscription fee, to hold the ETF. Most passive ETFs have MERs under 1%, and some can be just a few basis points (one-hundredth of a percent). Fees are important, but they are not the most important thing to consider. In my opinion, analyzing ETFs based on fees comes after all other things have been taken into consideration. When all else is equal, choose the ETF based on the lowest cost.
The market price is the price that investors can buy or sell an ETF on an exchange. With most investments, you can’t compare them based on price. If stock X is $50 and stock Y is $100, that doesn’t mean that stock X is a good deal and stock Y is not. That number has nothing to do with future performance and should be disregarded.
With any investment, you should never expect past performance to lead to future performance. I realize that analyzing past performance seems intuitive, but a passive strategy is about following the market, not attempting to beat it. Research on future performance based on past performance is also dismal. The few active managers that beat the market each period never continue to do so. Don’t look too heavily into the performance chart on any fund fact sheet.
The fund fact sheet will disclose when an ETF was launched. It’s worth noting that age doesn’t equal increased experience, nor does a recent launch date mean increased flexibility or innovation. I would be wary of a brand-new ETF only because there is less data to analyze; however, once a fund has been in existence for a few years, there isn’t a significant difference based on the date it launched.
New financial technology is making it easier than ever for individuals to invest, and ETFs are one of the easiest ways to do so. This doesn’t, however, diminish the due diligence required to make any form of investment. Investing for yourself may not be right for you, so I highly recommend doing your research and potentially speaking with a licensed professional. This article is simply for information sake and to further your understanding of a topic that I feel is getting some serious spotlight right now.
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