Pros and cons of ETF

Since its launch in 1993, exchange-traded funds (ETFs) have been popular with investors looking for alternatives to mutual funds. Institutions and individuals can see the benefits of these tools-a basket of assets is designed to track indexes with low management costs and greater visibility of intraday prices.

But of course, no investment is perfect. ETFs also have their shortcomings, from low dividends to large bid-ask spreads. Determining the strengths and weaknesses of ETFs can help investors manage risks and returns, and determine whether these 25-year-old securities are meaningful to their investment portfolios.

Key points

  • ETFs are considered low-risk investments because of their low cost, holding a basket of stocks or other securities, and increasing diversification.
  • For most individual investors, ETFs are an ideal asset type that can be used to build a diversified investment portfolio.
  • In addition, compared with actively managed funds, ETFs tend to have much lower expense ratios, can be more tax-efficient, and provide the option of reinvesting dividends immediately.
  • Nevertheless, holding ETFs and tax considerations based on the type of ETF may create unique risks.
  • Tools such as ETFs that rely on indexes for survival may die out due to indexes, and there is no flexible manager to protect performance from declines.

Pros and cons of ETF

Advantages of ETF

ETFs have many advantages, especially when compared to their mutual fund cousins.

diversification

An ETF can provide exposure to a set of stocks, market segments, or styles. ETFs can track a wider range of stocks and can even try to imitate the returns of a country or group of countries.

Trade like stocks

Although ETF may bring the benefits of diversification to holders, it has equity trading liquidity. especially:

  • ETF can buy and sell short on margin.
  • ETFs are traded at prices updated throughout the day. On the other hand, open-end mutual funds are priced at the net asset value at the end of the day.
  • ETFs also allow you to manage risk by trading futures and options like stocks.

Since ETFs are traded like stocks, you can use their stock codes to quickly find approximate daily price changes and compare them with their index industries or commodities. Many stock websites also have better chart operation interfaces than commodity websites, and even provide apps for your mobile device.

Lower cost

Compared with actively managed funds, passively managed ETFs have a much lower expense ratio, which is often the case for mutual funds. What drives up the expense ratio of mutual funds? Costs such as management fees, fund-level shareholder accounting fees, marketing and other service fees, payment of board fees, and loading fees for sales and distribution.

Reinvest dividends now

Dividends from companies in open-end ETFs are reinvested immediately, and the exact timing of reinvestment varies with index mutual funds. (One exception: the dividends of unit investment trust ETFs will not be automatically reinvested, causing dividends to be dragged down.)

Limited capital gains tax

ETFs can be more tax efficient than mutual funds. As a passively managed portfolio, the capital gains realized by ETFs (and index funds) are often lower than actively managed mutual funds.

On the other hand, if the manager sells securities for profit, the mutual fund must distribute the capital gains to shareholders. The allocated amount is allocated in proportion to the holder’s investment and is taxable. If other mutual fund holders sell before the record date, even if the overall value of the fund drops, the remaining holders will distribute capital gains and pay taxes accordingly.

Lower discount or premium

The probability of an ETF’s stock price being higher or lower than its actual value is low. ETFs trade at prices close to the price of the underlying securities throughout the day, so if the price is significantly higher or lower than the net asset value, arbitrage will bring the price back to consistency. Unlike closed-end index funds, ETFs trade based on supply and demand, and market makers will capture price differential profits.

Disadvantages of ETF

Although there are many advantages, ETFs also have disadvantages. in:

Less diverse

For certain industries or foreign stocks, investors may be limited to large-cap stocks due to the narrow stock group in the market index. Lack of exposure to small and medium-sized companies may prevent ETF investors from gaining potential growth opportunities.

Intraday pricing may be a bit overkill

The time horizon for long-term investors may be 10 to 15 years, so they may not benefit from intra-day pricing changes. Due to the lagging fluctuations in hourly prices, some investors may trade more. High volatility within a few hours can trigger trading, and pricing at the end of the day can prevent irrational concerns from distorting investment goals.

The cost may be higher

Most people compare trading ETFs with trading other funds, but if you compare ETFs with investing in specific stocks, the cost is higher. The actual commission paid to the broker may be the same, but there is no management fee for the stock. In addition, as more niche ETFs are created, they are more likely to follow a low volume index. This can lead to high bid-ask spreads. You may find a better price to invest in actual stocks.

Lower dividend yield

There are ETFs that pay dividends, but the yield may not be as good as owning high-yield stocks or a group of stocks. The risk of holding an ETF is usually low, but if investors can take the risk, the dividend yield on the stock may be much higher. Although you can choose stocks with the highest dividend yields, ETFs track a wider market, so the overall yield will be lower on average.

Leveraged ETF returns are skewed

A leveraged ETF is a fund that uses financial derivatives and debt to amplify the return on the underlying index. The loss of some double or triple leveraged ETFs may be twice or more than three times that of the tracking index. These types of speculative investments need to be carefully evaluated. If you hold an ETF for a long time, the actual loss may increase exponentially.

For example, if you have a dual-leverage natural gas ETF, a 1% change in natural gas prices should result in a 2% change in the ETF every day. However, if the leveraged ETF is held for more than one day, the overall return of the ETF will be significantly different from the overall return of the underlying securities.

period Double Leverage ETF ($) ETF percentage change Natural gas price ($) Nat.Gas percentage 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% 6.5 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 that you will see double returns on the index. The convenience of investing in leveraged ETFs may attract individuals with little experience or understanding of investment tools.

Bottom line

ETFs are used by various investors to build investment portfolios or gain exposure to specific industries. They are traded like stocks, but they can also be compared with a wider range of investments or even the entire index in terms of price changes. They have many advantages, especially when compared to other managed funds such as mutual funds.

But before placing an order to buy an ETF, there are also some shortcomings to be aware of. In terms of diversification and dividends, the options may be more limited. Tools such as ETFs that rely on indexes for survival may also die from indexes-there is no flexible manager to protect performance from declines. Finally, when deciding whether they are suitable for you, you need to consider the tax implications associated with ETFs (as with any investment).

InvestingClue does not provide tax, investment or financial services and advice. The information provided does not take into account the investment objectives, risk tolerance or financial situation of any particular investor, and may not be suitable for all investors. Investment involves risks, including possible loss of principal.

.

READ ALSO:   Currency ETF
Share your love