Exchange-traded funds (ETFs) have become a popular means of investment for both institutional and private investors, as an alternative to mutual funds and investment in individual stocks. However, before you invest in ETFs, you should be aware of the pros and cons associated with this class of securities.
Advantages
Diversifying to reduce risk
An ETF holds a group of equities, market segments, or investment styles. For instance, an ETF can track an index, or a broad range of stocks in an industry, or even stocks of a particular country or group of countries. That way it eliminates the stock-specific risk that you will have if you attempt to follow the same strategy as the ETF with only a small number of stocks.
Portfolio strategy and allocation
There are a wide variety of ETFs, covering a large number of indices and market segments. By investing in the appropriate ETFs, investors can quickly and easily implement an investment strategy or achieve a desired portfolio allocation, without the need to do extensive stock-specific research. Changing your asset allocation of rebalancing your portfolio can be done in less time and with fewer trades than would have been the case with buying stocks directly.
Similar to a stock
ETFs are traded like stocks and has characteristics similar to that of stocks. That is, you can buy and sell units in the ETF on the market in the same way as stocks. ETFs can be purchased on margin and sold short. You can often also trade in the derivative instruments of the ETFs, such as CFDs (contracts for difference). futures, and options.
Market price transparency
The market price of the ETF is readily available at any time on ticker services or trading platforms. Since ETFs are traded on the major stock exchanges, price charts are readily available from the same sources that supply stock charts. The price movements of an ETFs an often easily be compared with the movements of the stock or commodity index it attempts to replicate.
Lower fees
ETFs are passively managed and therefore have lower expense ratios, compared to actively managed funds. For instance, ETFs do not pay performance related management fees, shareholder accounting expenses, marketing service fees, directors’ remuneration, or load fees for sales and distribution. In addition, the cost of trading in an ETF will likely be lower than the cost of trading in a number of individual stocks.
Dividend reinvestment
The dividends earned by an open-ended ETF are reinvested immediately, unlike a mutual fund or a unity investment trust, where the reinvestment timing can vary, resulting in “dividend drag”. The ETF investor does not have to track and account for the dividends from the companies invested in.
Limited capital gains tax
In the United States, ETFs are generally more tax-efficient than mutual funds or investments in individual stocks. As passively managed portfolios, ETFs tend to realize fewer capital gains than actively managed funds. Furthermore, when an ETF sell and buys shares, it is considered an “in-kind redemption” which does not result in a tax charge.
In other countries, such as the United Kingdom, there is little difference in how ETFs and mutual funds are taxed. In fact, the tax treatment of capital gains and income from the ETF depends on the jurisdiction and status of the fund and on your personal tax circumstances. You would be well-advised to familiarize yourself with you country’s tax rules before diving into investments in ETFs, or other securities for that matter.
Lower discount or premium in price
As ETFs are traded throughout the day at a readily observed price, it its price is unlikely vary much from the calculated value based on the prices of the underlying index or securities. Arbitrage will ensure that the ETF price stays in line with the underlying. Market makers will quickly capture any price discrepancy profits.
Disadvantages
Large Cap Stock Bias
ETFs require a high degree of liquidity in the underlying stocks they are invested in. This means that your investment in ETFs will reflect a bias towards large cap stocks. This may result in your investment under-performing in a scenario where medium and small cap stocks outperform large cap stocks.
Real-time Pricing and Over-trading
Since ETFs trade like stocks on the market, price fluctuations may induce you to trade in and out unnecessarily. Some may argue that in this respect, mutual funds may have the advantage, because the short term trading decisions are taken out of your hands.
Costs Compared to Individual Stocks
Whilst the broker commission may be the same for ETFs as for individual stocks, ETFs carry a management fee which normally comes off your income from the fund. Moreover, specialized ETFs may trade a higher bid-ask spread than large cap stocks.
Lower Dividend Yields
If you invest in an ETF for its high dividend yield, you may end up receiving a lower dividend yield than you would have earned from a carefully selected portfolio of stocks. The reason for this is that, to fulfill their mandate, ETFs have to invest in a wide range of low-risk stocks, which would inevitably include stocks trading at lower dividend yields.
Overall, for investors with limited funds and time, investing in ETFs is a cost-effective way to achieve instant diversification, and hence a lower risk profile. ETFs also provide you with an efficient means to achieve your target asset allocation and to rebalance your portfolio. ETFs save you the time and effort you will have to expend in researching, tracking and trading in a portfolio of individual stocks.
Featured image courtesy of Marco Verch. CC By 2.0.