Exchange traded funds (ETFs) are excellent investment vehicles for both small and large investors. Similar to mutual funds, but traded like stocks, these popular funds are for investors looking to add diversity to their portfolios without the additional time and effort it takes to manage and allocate investments. It has become a popular choice among homeowners.
However, investors should be aware of some drawbacks before diving into the world of ETFs.
ETFs are often defined as a mutual fund that trades like a stock (on an exchange) and this is a good way to think about ETFs — assuming you have a crystal clear understanding of mutual funds and stocks.
Perhaps a comparison of mutual funds, index funds, and ETFs will help clarify how each investment works:
ETFs:
ETFs are very similar to index funds in that they enable you to invest in a preset group of investments — most often an index. The difference between an ETF and an index fund is the way they are traded. You can purchase an ETF in the same way you purchase stock and the costs of ETFs can be quite low.
Explore some of the benefits of ETFs below.
Pros and Cons of ETFs
There are many pros and cons of ETFs — mostly pros (at least for ETFs tracking a major index).
Pro of an ETF: Diversification
One of the key goals of any good asset allocation strategy is diversification — being invested in a variety of asset classes and a range of companies within each asset class.
ETFs can be the ultimate in diversification, allowing you to have broad exposure to a predetermined set of assets (as opposed to holding individual stocks)
Pro: Transparency
With most ETFs, investors can see the underlying portfolio daily. Mutual funds are only required to report their holdings a couple of times during the year.
Pro: Trade Like Stocks
Just like individual shares of stock, ETFs can be bought and sold during the day while the stock exchange is open. Mutual fund orders must be submitted before the close of the market (earlier in the day for some funds) with the purchase or sale occurring after the close of trading for that day.
While there are distinct disadvantages to day-trading and market timing, it is nice to be able to get in or out of an ETF as needed.
This also means that market orders such as stop orders, limit orders, and others can be placed on an ETF to trigger a trade if the price hits a certain level (up or down). This is the same as with shares of individual stocks. ETFs can also be sold short, a bet on a price decrease. You can even buy or sell options against ETFs, even if it most probably isn’t a smart move.
Pro: Cheap to Own
Many ETFs are very cheap to own. This is especially true with a number of index ETFs such as:
- Vanguard Total Stock Market (ticker VTI) has an expense ratio of 0.04%.
- Spider S&P 500 Index ETF (SPY), one of the oldest and largest ETFs has an expense ratio of 0.09%.
This can make low-cost ETFs a good idea for long-term investors and a good vehicle for retirement investing. Fees and expenses are a critical factor in your long-term investing success and low-cost ETFs can play a role.
NOTE: Not all ETFs are low in cost, you will need to research this and other aspects of any ETF that you may be considering.
FINRA recommends that before making any ETF investment that you carefully read all of the ETF’s available information, including its prospectus.
Pro: Low Minimum to Invest
Mutual funds (even index funds) typically have a minimum buy-in investment, usually in the 4–5 figure range. For those of us just starting to invest — or who don’t want to invest up to that rather-high minimum — traditionally, we’d be out of luck.
Enter ETFs. Now the minimum investment is just one share. With certain brokerage houses, you may even be able to buy a fraction of a share to start with!
Pro and Con of an ETF: They Can Go Beyond the Stock Indexes
Passive index ETFs tracking benchmarks like the S&P 500, the Russell 1000 and 2000 indexes, the Barclays Aggregate Bond Index, and other widely followed stock and bond indexes are probably the most prevalent types of ETFs.
However, with interest in ETFs on both the part of the investing public and institutional investors, the number of types of ETFs have proliferated. There are now ETFs that:
- Are actively managed
- Follow alternative investment strategies
- Are comprised of bonds
- And more…
One of the areas of growth in ETFs in recent years is in smart beta ETFs. Essentially these are ETFs that start with an index but then specialize in a specific investing goal or type of company. Common types of smart beta ETFs include:
- Dividends — companies within an index that are more likely to pay out dividends
- Quality Momentum
- Size (for example small cap)
- Low volatility
- And others
Pro: The growing diversity of different kinds of ETFs is positive in that you can find an option that best suits your investing needs.
Con: The diversity is also a negative in that it can cause confusion and some of the real original benefits of an ETF — a low cost and simple way to own the entire market — can be lost.
As always, know exactly what you are investing in and understand the fees that are built into the investment.
Pro and Con of an ETF: Liquidity
Liquidity pertains to the ability to readily trade a security at or near its market value. Some ETFs have a lot of liquidity. Others do not.
Pro: ETFs that have a high daily trading volume and that track popular indexes like the S&P 500 will not have an issue with liquidity. You will likely be able to sell the investment when you want to.
Con: Some ETF asset classes, such as bonds, are not as liquid. For bonds and other asset classes such as commodities, real estate, and some foreign securities, ETFs may be more difficult to sell exactly when you want to.
Pro and Con of an ETF: Regulatory Structures
FINRA states that “Most ETFs are registered with the SEC as investment companies under the Investment Company Act of 1940, and the shares they offer to the public are registered under the Securities Act of 1933. Some ETFs that invest in commodities, currencies or commodity or currency-based instruments are not registered investment companies, although their publicly-offered shares are registered under the Securities Act.”
Be aware of exactly what you are buying and how it is regulated.
Con of an ETF: Again, You Need to Be Aware of What You Are Buying
With the proliferation of different kinds of ETFs, you need to be aware of what you are buying.
The Securities and Exchange Commission (SEC) advises, “Certain ETFs can be relatively easy to understand. Other ETFs may have unusual investment objectives or use complex investment strategies that may be more difficult to understand and fit into an investor’s investment portfolio. For example, “leveraged ETFs” seek to achieve performance equal to a multiple of an index after fees and expenses. These ETFs seek to achieve their investment objective on a daily basis only, potentially making them unsuitable for long-term investors.”
KEY TAKEAWAYS
- Exchange-traded funds (ETFs) have become incredibly popular investments for both active and passive investors alike.
- While ETFs provide low-cost access to a variety of asset classes, industry sectors, and international markets, they do carry some unique risks.
- Understanding the particulars of ETF investing is important so that you are not caught off guard in case something happens.
Commissions and Expenses
One of the biggest advantages of ETFs is that they trade like stocks. An ETF invests in a portfolio of separate companies, typically linked by a common sector or theme. Investors simply buy the ETF to reap the benefits of investing in that larger portfolio all at once.1
As a result of the stock-like nature of ETFs, investors can buy and sell during market hours, as well as enter advanced orders on the purchase, such as limits and stops.1 Conversely, a typical mutual fund purchase is made after the market closes, once the net asset value of the fund is calculated.
Every time you buy or sell a stock, you might pay a commission.3 This is also the case when it comes to buying and selling ETFs. Depending on how often you trade an ETF, trading fees can quickly add up and reduce your investment’s performance. No-load mutual funds, on the other hand, are sold without a commission or sales charge—making them relatively advantageous, in this regard, vs. ETFs.4 It is important to be aware of trading fees when comparing an investment in ETFs with a similar investment in a mutual fund.
Many online brokers today offer zero-commission trading in stocks and ETFs. Note, however, that you may still pay a hidden commission in the form of payment for order flow (PFOF). This controversial practice routes your orders to a specific counterparty rather than having the market compete for your order at the best price possible.5
If you are deciding between similar ETFs and mutual funds, be aware of the different fee structures of each, including the trading fees that may be generated inside of actively managed ETFs. And remember, actively trading ETFs, as with stocks, can reduce your investment performance with commissions quickly piling up.
Every ETF will also come with an expense ratio. The expense ratio is a measure of what percentage of a fund’s total assets are required to cover various operating expenses each year.4 While this is not exactly the same as a fee that an investor pays to the fund, it has a similar effect: The higher the expense ratio, the lower the total returns will be for investors. ETFs are known for having very low expense ratios relative to many other investment vehicles, but they are still a factor to consider, especially when comparing otherwise similar ETFs.
Underlying Fluctuations and Risks
ETFs, like mutual funds, are often lauded for the diversification that they offer investors. However, it is important to note that just because an ETF contains more than one underlying position doesn’t mean that it is immune to volatility. The potential for large swings will mainly depend on the scope of the fund. An ETF that tracks a broad market index such as the S&P 500 is likely to be less volatile than an ETF that tracks a specific industry or sector, such as an oil services ETF.
Therefore, it is vital to be aware of the fund’s focus and what types of investments it includes. As ETFs have continued to grow increasingly specific along with the solidification and popularization of the industry, this has become even more of a concern.
In the case of international or global ETFs, the fundamentals of the country that the ETF is following are important, as is the creditworthiness of the currency in that country. Economic and social instability will also play a huge role in determining the success of any ETF that invests in a particular country or region. These factors must be kept in mind when making decisions regarding the viability of an ETF.6
The rule here is to know what the ETF is tracking and understand the underlying risks associated with it. Don’t be lulled into thinking that all ETFs are the same just because some offer low volatility.
Tracking error measures how closely an index ETF tracks its benchmark index.7 Those with larger tracking errors may come with hidden risks.
Low Liquidity
A big factor in trading an ETF, a stock, or anything else that is traded publicly is liquidity. Liquidity means that when you buy something, there is enough trading interest that you will be able to get out of it relatively quickly without moving the price.
If an ETF is thinly traded, there can be problems getting out of the investment, depending on the size of your position relative to the average trading volume. The biggest sign of an illiquid investment is large spreads between the bid and the ask. You need to make sure that an ETF is liquid before buying it, and the best way to do this is to study the spreads and the market movements over a week or month.
The rule here is to make sure that the ETF in which you are interested does not have large spreads between the bid and ask prices. Tighter spreads equal greater liquidity, and that corresponds with less risk in entering and exiting your trades.
Capital Gains Distributions
In some cases, an ETF will distribute capital gains to shareholders. This is not always desirable for ETF holders, as shareholders are responsible for paying the capital gains tax.1 It is usually better if the fund retains the capital gains and invests them, rather than distributing them and creating a tax liability for the investor. Investors will usually want to reinvest those capital gains distributions; to do this, they will need to go back to their brokers to buy more shares, which creates new fees.
Because different ETFs treat capital gains distributions in various ways, it can be a challenge for investors to stay apprised of the funds in which they take part. It’s also crucial for an investor to learn about how an ETF treats capital gains distributions before investing in that fund.