Since their introduction in 1993, exchange-traded funds (ETFs) have exploded in popularity with investors.
These instruments—equity portfolios tracking an index and tradable intraday like stocks—have provided cost savings and diversification benefits for institutional managers as well as individuals.
Of course, ETFs have pitfalls as well, from low liquidity in some cases to the risk and complexities of the most speculative varieties of exchange-traded funds.
Identifying the advantages and disadvantages of ETFs can help investors decide whether these securities make sense for their portfolios, and to maximize their rewards while reducing the risks.
Key Takeaways
- ETFs are considered to be low-risk investments because they are low-cost and hold a basket of stocks or other securities, increasing diversification.
- For most individual investors, ETFs represent an ideal type of asset with which to build a diversified portfolio.
- In addition, ETFs tend to have much lower expense ratios compared to actively managed funds, can be more tax-efficient, and offer the option to immediately reinvest dividends.
- Still, unique risks can arise from holding ETFs as well as tax considerations, depending on the type of ETF.
- Vehicles like ETFs that live by an index can die by an index since no nimble manager is involved to shield performance from a downward move.
Advantages of ETFs
ETFs, which compete with mutual funds and trade like stocks, have some notable advantages over both of those alternatives.
Diversification
One ETF can give investors exposure to many stocks from a particular industry, investment category, country, or a broad market index. ETFs can also provide exposure to asset classes other than equities, including bonds, currencies, and commodities.
Portfolio diversification reduces an investor's risk. Duplicating that benefit by buying individual stocks would be much more cumbersome in terms of the time, research, and trading required, and likely more expensive.
Trades Like a Stock
An investor requesting a mutual fund redemption during the trading day can't really be sure of the redemption price. That will depend on where the fund's net asset value lands when it's calculated at the end of the day. In contrast with mutual funds, ETFs:
- Trade at a market-based price updated throughout the trading day
- Can be purchased on margin and sold short
- May serve as underlying securities for option contracts
The most popular ETFstrade with more liquidity than most stocks. This means that there are always plenty of buyers and sellers and narrow bid-ask spreads.
Lower Fees
ETFs, which are passively managed, tend to have significantly lower expense ratios than actively managed mutual funds. What drives up a mutual fund's expense ratio? Costs such asa management fee, fund accounting and trading expenses, and load fees related to their sale and distribution.
Immediately Reinvested Dividends
The dividends of the companies in an open-ended ETF are reinvested immediately, whereas the exact timing for reinvestment can vary for index mutual funds. (One exception: Dividends in unit investment trust ETFs are not automatically reinvested, thus creating a dividend drag.)
Limited Capital Gains Tax
ETFs can be more tax-efficient than mutual funds. As passively managed portfolios, ETFs (and index mutual funds) tend to realize fewer capital gains than actively managed mutual funds.
Mutual funds, on the other hand, are required to distribute capital gains to shareholders if the manager sells securities for a profit. This distribution amount is made according to the proportion of the holders' investment and is taxable.
If other mutual fund holders sell before the date of record, the remaining holders divide up the capital gain and thus pay taxes even if the fund overall went down in value.
Lower Discount or Premium in Price
There is a lesser chance of ETF share prices being higher or lower than those of underlying shares. ETFs trade throughout the day at a price close to the price of the underlying securities, so if the price is significantly higher or lower than the net asset value, arbitrage will bring the price back in line.
Unlike closed-end index funds, ETFs trade based on supply and demand, and market makers will capture price discrepancy profits.
One minor risk of ETFs (though not unique to them) is shutdown risk, or the risk that an ETF will close. While shareholders would get their money back, there can be annoyances other than having to reinvest your money. These can include capital gains taxes that investors are unprepared for and potentially unexpected fees.
Disadvantages of ETFs
While the pros are many, ETFs carry drawbacks too. Among them:
Less Diversification
For some sectors or foreign stocks, ETF investors might be limited to large-cap stocks due to a narrow group of equities in the market index. A lack of exposure to mid- and small-cap companies could leave potential growth opportunities out of the reach of certain ETF investors.
Intraday Pricing Might Cause Unwise Trading
Longer-term investors could have a time horizon of 10 to 15 or more years, and intraday price movements could induce them to trade unnecessarily. In fact, a big swing over a couple of hours could prompt emotional trading where pricing at the end of the day could keep irrational fears from distorting an investment objective.
Costs Could Be Higher
Most people compare trading ETFs with trading other funds. Yet, if you compare ETFs to investing in a specific stock, then the ETF costs are higher. The actual commission paid to the broker might be the same, but there is no management fee for a stock.
Also, as more niche ETFs are created, they are more likely to follow a low-volume index. This could result in a wide bid/ask spread. Consequently, you might find a better price investing in the actual stocks.
Lower Dividend Yields
There are dividend-paying ETFs, but the yields may not be as high as those obtained by owning a high-yielding stock or group of stocks. The risks associated with owning ETFs are usually lower than those of individual stocks.
But if an investor can take on the risk, then owning individual stocks can mean much higher dividend yields. While you can pick the stock with the highest dividend yield,ETFs track a broader market, so the overall yield will average out to be lower.
Skewed Leveraged ETF Returns
A leveraged ETF is a fund that uses financial derivatives and debt to amplify the returns of an underlying index. Certain double or triple-leveraged ETFs can lose more than double or triple the value change of the tracked index. Therefore, these types of speculative investments need to be carefully evaluated. If the ETF is held for a long time, the actual loss could multiply fast.
For instance, if you own a double-leveraged natural gas ETF, a 1% change in the price of natural gas should result in a 2% change in the ETF on a daily basis. However, if a leveraged ETF is held for greater than one day, the overall return from the ETF will vary significantly from the overall return on the underlying security.
| Value Changes of Double-Leveraged ETF vs. Index | ||||
|---|---|---|---|---|
| Period | Double-Leveraged ETF ($) | ETF % Change | Natural Gas Price ($) | Nat. Gas % Change |
| 1 | 10 | 7.00 | ||
| 2 | 8.80 | -12.00% | 6.58 | -6.00% |
| 3 | 8.53 | -3.04% | 6.48 | -1.52% |
| 4 | 7.93 | -7.10% | 6.25 | -3.55% |
| 5 | 8.56 | 8.00% | 6.50 | 4.00% |
| 6 | 7.35 | -14.15% | 6.04 | -7.08% |
| 7 | 8.47 | 15.23% | 6.50 | 7.62% |
| 8 | 9.77 | 15.38% | 7.00 | 7.69% |
| Total % Change | -2.28% | 0.00% | ||
A double-leveraged ETF does not always mean you will see double the return of the index. And the ease of investing in leveraged ETFs could entice individuals with little experience or understanding of the investment vehicle to invest when they should not.
Who Should Invest in ETFs?
ETFs can be a great investment for long-term investors and those with shorter-term time horizons. They can be especially valuable to beginning investors. That's because they won't require the time, effort, and experience needed to research individual stocks. The cost to own an ETF may be lower than the cost to buy a diversified selection of individual stocks, too.
Why Invest in ETFs Rather Than Mutual Funds?
ETFs can be less expensive to own than mutual funds. Plus, they trade continuously throughout exchange hours, and such flexibility may matter to certain investors. ETFs also can result in lower taxes from capital gains, since they're a passive security that tracks an index.
What's the Biggest Risk of Owning an ETF?
The greatest risk for investors is market risk. If the underlying index that an ETF tracks drops in value by 30% due to unfavorable market price movements, the value of the ETF will drop as well.
The Bottom Line
ETFs are used by a wide variety of investors to build a portfolio or to gain exposure to specific sectors. They can make up a portion of your portfolio or be the only type of security you invest with.
They are like stocks in the waythey trade but can also be compared to broader investments, or even entire indexes, in their price movements. In addition, they have many advantages, especially compared to managed funds (such as some mutual funds).
But ETFs have their disadvantages. When it comes to diversification and dividends, certain ETFs may have limitations. And, investment vehicles like ETFs that live by an index can also die by an index—since no nimble manager is involved to shield performance from a downward move.
Finally, the tax implications of ETFs must also be considered when deciding if they are the right investment for you.
Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circ*mstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.
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