No investment is ideal and the same is true for ETFs (Exchange Traded Funds). ETFs have their downsides as well (low dividends, large bid-ask spreads). Understanding the advantages and disadvantages of ETFs can aid investors to navigate the risks and rewards. By doing so, they’re able to decide whether these securities are a good fit for their portfolio.
Here are the pros and cons to help you make that decision:
Advantages of ETFs
1. Diversification
While it’s easy to think of diversification in terms of the broad market verticals such as stocks, bonds or a particular commodity, there’s more. ETFs also allow investors to diversify across horizontals like industries. Normally, it would require a lot of money and effort to buy all the components of a particular basket. However, when it comes to ETFs, you can get them at the click of one button.
2. Transparency
Anyone with access to the internet can search the price activity for a particular ETF on an exchange. In addition, a fund’s holdings are disclosed each day to the public. Contrary to mutual funds, where that happens quarterly or monthly.
3. Tax Benefits
Investors typically are taxed only upon selling the investment. In comparison, mutual funds incur such burdens over the course of the investment.
4. Lower Fees
ETFs, which are passively managed, have much lower expense ratios. Actively managed funds, which mutual funds tend to have higher rates. What drives up a mutual fund’s expense ratio? Costs such as a management fee, shareholder accounting expenses at the fund level, service fees like marketing, paying a board of directors, and load fees for sale and distribution.
Disadvantages of ETFs
1. Less Diversification
For certain sectors or foreign stocks, investors might be limited to large-cap stocks. This occurs due to a narrow group of equities in the market index. A lack of exposure to small to mid-sized companies could leave potential growth opportunities out of reach for ETF investors.
2. Intraday Pricing Might Be Overkill
Longer-term investors could have a time horizon of 10 to 15 years. Because of this, they may not benefit from the daily price changes. Some investors may trade more due to these varying swings in hourly pricing. A high swing over a couple of hours could induce a trade where pricing at the end of the day could keep irrational fears from distorting an investment objective.
3. Costs Could Be Higher
Most people compare trading ETFs with trading other funds. However, if you compare ETFs to investing in a specific stock, the overall 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’re more likely to follow a low-volume index. This could result in a high bid/ask spread. You might find a better price investing in the actual stocks.
4. Lower Dividend Yields
While there are dividend-paying ETFs, their yields might not be as high as owning a high-yielding stock/group of stocks. The risks associated with owning ETFs are usually lower. If an investor can take on the risk, then the dividend yields of stocks can be much higher. 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.
While you weigh the pros and cons in your ultimate decision to invest in ETFs or not, let’s also get you thinking about your financial stability.