Should You Buy a High-interest ETF?

Andrew Hepburn
by Andrew Hepburn May 3, 2016 / No Comments

You’ve probably heard of exchange-traded funds (ETFs). And chances are you’ve also heard about high-interest savings accounts. But have you heard about high-interest savings ETFs?

High-interest savings ETFs are a relatively new phenomenon. They aim to combine the benefits of an ETF with the returns associated with high-interest savings accounts.

Are these something you might want to consider?

First, let’s take a look at exactly what these products are and how they work.

An ETF is sort of like a mutual fund in the sense that it pools many different people’s assets together. Unlike mutual funds, ETFs trade on a stock exchange. In addition, they usually can’t be redeemed in the manner that a mutual fund can be. In other words, if you want to sell your ETF, you don’t send in a redemption request to the company that manages it. Instead, you just sell it to someone else.

With a high-interest savings ETF, the fund manager takes the money of various investors and places it with one or more Canadian banks or credit unions. These financial institutions pay interest on the funds. In turn, the ETF manager uses the interest to give holders of the ETF a return on their money (after taking a small slice as a management fee).

All told, the return you receive by owning a high-interest savings ETF is roughly comparable to having your own high-interest savings account.

Advantages and disadvantages

There are two benefits to owning a high-interest savings ETF. First, the interest you’ll receive will be competitive with many high-interest savings accounts you could open by yourself. Second, and arguably more important, buying them is really as easy as purchasing a stock. As long as you already have an online brokerage account, putting money into a high-interest savings ETF takes very little time. Unlike an actual high-interest savings account, you don’t have to go through the whole process of applying and transferring in funds.

But before you decide to buy a high-interest savings ETF, there are some things to keep in mind. First off, unlike an actual savings account, these products are not CDIC-insured. If the bank that’s paying the ETF interest somehow goes bust, you may not get your investment back.

Second, when you buy a stock you pay commissions (again, unlike savings accounts). And given how low interest rates are these days, those commissions can seriously eat into your returns with a high-interest ETF.

For example, imagine you invest $10,000 of your savings into one of these products, and the ETF yields 1.5%. That’s a pre-tax annual return of $150. Except that if you’re paying $10 in commission to buy the product and another $10 if you sell within the same year, that’s $20 coming out of your total return. This brings your pre-tax return down to 1.3%. It’s not a huge difference, but it’s something to keep in mind.

What else to watch for

Now for something a bit on the technical side, because as they say, the devil’s in the details.

As a general rule, ETFs trade very close to what’s called their net asset value (NAV). What this means is that if the assets held by the ETF, minus any liabilities, are worth say $10 per share, the share price should be very close to $10.

The way ETFs ensure the share price stays close to the NAV is due to a process called arbitrage. This is just a fancy way of saying that if the shares are worth $10 but only trading for $9.80, someone will step in and buy shares until they’re very close to the $10 mark. They do this because it’s seen as a riskless way of making money. Typically, an ETF manager will appoint banks or brokerage firms to act as what’s called a market maker in this regard, stepping in to buy or sell the ETF if it starts to deviate from its net asset value.

It would be highly unusual but if the market makers of a high-interest savings ETF weren’t willing or able to buy shares should the price fall below the NAV, an investor might lose money. For example, if the shares are trading at $9.50 even though they’re really worth $10, that’s a loss of 5%. Given that you’re only getting a net return of perhaps 1.30% as is, the potential for this kind of loss is something to be aware of.

So there you have it. An informed investor is a better investor. And now you know about high-interest savings ETFs.

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Flickr: KMR Photography