How to Invest in ETFs

ETF investing may be easier for you to get into than stocks, especially if you feel you lack financial literacy. Nonetheless, there are several things you need to understand before you start buying random investments and calling it quits. To guide you through your newly discovered ETF path, Trackinsight has put together a handful of easy steps to guide you in owning your first Equity ETF, highlighting insightful resources from BMO Exchange Traded Funds.

Step 1 - Understanding what you're getting into

Exchange-Traded Funds (“ETFs”) are one of the most popular investment products today. Investors have adopted ETFs for their many benefits such as quick diversification, low costs, and easy trading. As their name suggests, ETFs have two defining characteristics: they are funds, and they trade on an exchange. This sounds simple, right? Here are the main things that you need to know before you move on to step 2:

• What is Diversification?
• What are ETFs?
• A Brief History of ETFs (optional)
• ETFs vs Index Funds: What is the difference?
• 5 Benefits of ETFs for Investors

Step 2 – Choosing what to invest in

Know why you are investing

Whether you have financial literacy or not, choosing what to invest in is not an easy task. First, you should be clear about why you are investing and what you expect. This could be as simple as "I want my money to grow faster than inflation" or "I want to retire early", but it could also be "I want to invest to afford my children’s college tuition fees" or "I want regular investment income."

Assess your risk tolerance

In general, the amount of return you can expect from an investment is linked to the level of risk you can take. The higher the risk, the greater the potential for higher returns – and losses. Understanding how much risk you can take will help determine what combination of assets you need to invest in to achieve your goal.

Investors with lower risk profiles might invest more in high-quality government bonds and less in stocks. The higher your tolerance for risk, the more you can invest in riskier assets like emerging stocks or commodities. That said, regardless of the level of risk you are comfortable with, it is key to build a diversified portfolio.

Gain wisdom on investing topics

Now that you have narrowed down the options, it is time to dive deeper into the world of ETF investing. You should be curious and committed to reading news and updates on stocks, sectors, industries, economic growth, inflation, and pretty much everything about investing. Once you get exposed to a constant influx of information, you will start to have a feel of what might be a good investment for you in the long run. However, it is imperative to diversify your sources of information and avoid common cognitive biases experienced by new investors like Recency Bias, Herd Bias, Confirmation Bias, and Anchoring Bias among others.

Additional resources that can help build your knowledge on different types of ETFs:

• What are Active ETFs?
• What are Commodity ETFs?
• What are Thematic ETFs?
• Sector vs. Thematic ETFs: What's the difference?
• Fixed Income Investing: A Guide to Bond ETFs
• What are ESG ETFs?
• Understanding Leverage ETFs

Step 3 – Finding ETFs

With an investment idea in mind, you can start looking for the right ETFs to implement it. Just head over to Trackinsight's free ETF Screener where you can explore over 8,000 ETFs with their detailed fact sheets. If you are interested in Energy ETFs for example, just type the word Energy in the search box and let the platform's algorithm do its magic.

You can also check out our new Thematic Investing Channel - an "all you can dream Thematic ETFs buffet." You can discover the world of investing in megatrends, trends, and themes that will shape our future like Future Mobility, Robotics, Smart Cities, and much more.

Whatever you are looking for, you are most probably going to end up with a long list of ETFs. The next step is to understand ETF characteristics, so you can compare between funds and narrow down your list to a handful of options.

Step 4 – Comparing ETFs

The moment of truth is here, and you are one step closer to investing in your first ETF. Like all the products you find on a store shelf, ETFs have characteristics you need to comprehend before you make up your mind. By understanding those features, you will avoid costly mistakes that may hinder your ability to become a great ETF investor.

Those characteristics include:

• Active or Passive ETFs
• Holdings
• Concentration
• Performance 
• Total Expense Ratio (TER)
• Liquidity
• P/E ratio
• Distribution
• Sustainability/ESG

Active or Passive ETFs

If you read the list of suggested articles in Step 2, then you know what we are talking about. Investing in an Active ETF means you are betting on the fund manager to guide your investments through choppy markets and do the proper trades when necessary. You need to make sure to read his/her credentials and find if he/she had a historical success of beating the benchmarks.

With a passive ETF however, you are betting that an index will prevail over time. In that case, focus on understanding the index, how it is constructed and what it is made of (holdings). You can learn more about indices, the backbone of ETFs here.

Holdings

Analyzing the underlying assets held by an ETF is important because it will be the driving force of its performance. ETF issuers typically publish daily on their website the list of all the holdings of the ETF and each of their respective weightings. You can also focus on the top 10 holdings and read their recent quarterly or annual reports. You can go deeper to try to understand their business model, analyze their sales growth, top-line, and bottom-line profitability, and the health status of their balance sheet. If you have good financial literacy then you know what to look for, but if not, you can always reach out to an expert friend or an outside professional if deemed necessary.

Concentration

One of the main perks of investing in ETFs is diversification. You gain exposure to a basket of stocks from companies operating in different regions, sectors, industries, or themes. It is therefore crucial for you to assess the fund's allocations and the concentration of those allocations. For instance, if a fund has dozens of stocks but has allocated 80% or more to the top 5, it may be problematic when one of these companies underperforms for some reason. The more an ETF is diversified across different spectrums, the fewer stock-specific risks you take on.

Performance

Comparing the performance of two ETFs over a certain period is important but does not mean you go with the best performing ETF every time. The outperformance of one ETF over another is just another question for you to answer. You need to understand why this ETF had done better than its peer, especially if they have the same focus. In that case, you need to dig deeper into the fund's allocations and see if this performance is linked to an exceptional holding that fared well during that period while being overweight. By understanding what the ETFs are made of you can improve your picking skills. And always remember the investment industry motto: "Past performance is no guarantee of future results."

Total Expense Ratio (TER)

Total Expense Ratios (TER) are what the ETF issuers will charge you every year for owning their ETFs. These fees are used to cover the fund's administrative, management, advertising expenses. So, if the TER is 1% and you have $10,000 worth of ETF shares, that means you will pay $100 in fees every year. The TER allows you to compare the cost incurred with those of other ETFs. It does not mean that you should go with the cheapest, but it could be a tiebreaker when comparing two vanilla funds that track the same index (A Vanilla ETF is generally an ETF that tracks a broad underlying index, such as the S&P 500).

Liquidity

Liquid investments are investments that you can quickly turn into cash. Investors who hold ETFs that are not liquid enough may have trouble selling them at the price they want or in the time frame necessary. An ETF’s liquidity is linked to the trading volume of the securities that it holds, the trading volume of the ETF itself, and the overall market appetite. So, to properly evaluate an ETF's liquidity, you need to analyze the liquidity of its main holdings (volume, bid/ask price spread) and the liquidity of the ETF itself (volume, bid/ask price spread). High volume and tight spreads are favorable, low volume and wide spreads are not.

P/E ratio

A P/E ratio is a multiple used to value a company. It is measured by dividing its current share price relative to its earnings per share (EPS). Analysts use this ratio (and other multiples) to compare a certain stock with its peers in the same industry or sector. If the company's P/E ratio is lower than its peers, then the company may be undervalued, and vice versa. The P/E ratio of an equity ETF is the weighted average of the P/E ratios of all the underlying stocks. It is a good idea to compare P/E ratios of ETFs tracking a given industry or sector. If one ETF has a much higher P/E than the industry average and a similar ETF, then the ETF may be invested in potentially overvalued or high-growth stocks, which is risky if investors start cashing out.

Distribution

If you are looking for ETFs that pay dividends, then you can check out their distribution frequency and yield. The yield is how much dividend you get for every dollar you invested. If you have $10,000 invested in an ETF with a distribution yield of 1%, that means you get $100 in dividends paid out (some taxes may have to be paid). The frequency is how many times a year they pay you dividends. It could be annually, semi-annually, quarterly, or in some cases — monthly.

Sustainability / ESG

If you want to use your money to help change the world, ESG investing may be right for you. By putting your funds in ESG ETFs, you are supporting companies that can provide a better future for people and our planet. ESG principles promote more environmentally friendly investing, support the companies with strong governance and eschew those who do not facilitate social change. If you are worried that you would be sacrificing returns, don't be! New research has shown that ESG investing does not necessarily drag on performance, but in fact, it could enhance it. So, if you opt for ESG funds and they perform over time, know that you are in a win-win situation.

Step 5 – Find a Broker

Now that you have finished ETF 101 and decided to take on the world of ETF investing, it's time for you to buy your first ETF. There are many online brokers and trading platforms that would happily accept your money, and some won't. Rules and regulations are different from one country to another and of course, from one broker to another. Some will only welcome accredited investors and others will happily spend 30 minutes with you to tell you how to invest your first $100.

It is vital to find the list of all available brokers in your country and check they are authorized by local regulators. Since you may end up with a long list, make sure to compare their product offering, fees, limitations, platform features, and other services. Reading online reviews is always helpful, but nothing is better than a word of mouth from a family member, friend, or coworker, so make sure to ask around.

Once you have selected a broker, you need to be prepared to provide a list of documents and sign the paperwork. Don't worry, most of the processes these days are digitalized with integrated AI and facial recognition software.

Step 6 – Buying your first ETF

After conducting a thorough due diligence review, you signed up for a new trading account and you are now ready to buy your first ETF. But before you make a move with your first $5,000, you need to decide whether you go all in or invest in increments, or in business terms, lump sum, or dollar-cost averaging. Since no-fee stocks and ETF trading has become the norm in recent years, broker commissions no longer eat away capital as they used to.

If you go with lump-sum investing, it means that you put the entire $5,000 investment to work right away in one transaction, which is great in a steady bull market, but perhaps not optimal if the market looks like it is peaking or is unusually volatile.

With dollar-cost averaging, you spread the investment with periodic investments (e.g., $1,000 a month). While this strategy works well in a bear market, it does have an opportunity cost if the market goes up when only part of your money is in there. The main upside of this strategy is that it helps take the emotion out of investing. It pushes you to continue investing the same (more or less) amount regardless of the market's fluctuations, potentially helping you avoid the temptation of timing the market.

Step 7 – Stay up to date with your ETFs

Using the selected broker platform, you have bought your first ETF. But if you thought that it is the end of the process, then you are wrong. While ETF investing is for the long run, it does not mean you get to kick back and relax. There is extra work to be done, especially the things we mentioned in step 2 about gaining wisdom. We recommend you follow your ETF provider for updates, especially the ETF's periodical reports, and fact sheets. That way you can stay up to speed with your investment and find out if you need to make a move.

Due diligence checklist by BMO ETFs

Did you know that Canada boasts the first ETF — the Toronto 35 Index Participation Units (Now XIU ETF, Source)— and beats the U.S. to bring a Bitcoin ETF to the market? Canadians have a history of ETF innovation, so we have leaned on BMO ETFs, a leading provider of Exchange-traded funds in Canada for 11 years, with over 100 strategies and approximately 30% market share in Canada — to provide helpful insights on your path to buying your first-ever ETF.

According to BMO ETF specialists, you need to ask yourself these questions before buying an ETF:

Identifying the right provider  

• What are the firm’s total assets under management (AUM) and total ETF AUM?
• How experienced is the firm in managing & launching ETFs?
• What does the firm’s service model look like? Does it provide education? Trading support?
• Is the provider a leader in the industry? What ETFs does the product shelf include: broad-based, smart beta, fixed income, innovative solutions?
• Does the provider have relationships with major index providers?

Identifying the Right exposure

• Are the investment objectives clearly defined and is the portfolio aligned?
• Are the holdings available daily?
• Is the index widely recognized or does it provide an innovative exposure?
• How is the index weighted - market capitalization, rules-based?
• Is the ETF concentrated in a few holdings, sectors, or countries, or is it diversified?
• How tax-efficient is the yield?

Identifying the right structure

• Is the index provider widely recognized? How long has the index been in existence?
• What method does the ETF use to track its index – Optimized, Replicated, Sampling?
• Does the provider offer securities lending on its product suite? What are the limits?
• How many levels of withholding taxes are within the ETF structure and are they recoverable?
• Does the ETF hold derivatives?

Understanding the ETF's total cost

• What is the ETF's total cost?
• What is the average bid/ask spread on the ETF?
• How often is the ETF rebalanced and how are those costs minimized?
• What is the ETF's historical turnover?
• How closely does the ETF track its index or exposure?

Liquidity

• What is the average daily dollar volume of the ETF?
• What is the weighted average daily dollar volume of its underlying securities?
• How does the ETF maintain liquidity?
• Does the provider offer support to help investors receive the best execution?
• How has the ETF performed in stressed markets?

You can read more about BMO ETFs’ due diligence checklist here.

Trading tips by BMO ETFs

When you're trading ETFs, it's important to monitor market conditions and underlying exposures that could impact your trading activity. Remember to consider these tips when buying and selling ETFs.

• Avoid Trading on the Open & Close of the Market
• Always Use Limit Orders
• Trade When the Underlying Market is Open
• Awareness of Market Volatility

You can read more about BMO ETFs’ trading tips here.

And don't forget…

If you need inspiration before you buy your second fund, make sure to follow Trackinsight to keep up with the latest trends and insights on the world of ETFs.

Keep reading:

• How many ETFs should you own?
• Mythbusting Thematic ETFs