Advantages and Disadvantages of ETFs

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.

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 ETFs trade 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 as a 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.

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.

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.

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 way they 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.

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