Exchange-Traded Funds: Pros and Cons

• Exchange trade funds – ETFs – are a popular way of investing in broad indices or market segments.
• Unlike mutual funds, ETFs are listed on major exchanges and trade much like ordinary stocks.
• This makes them low-cost, highly liquid, and transparent securities for diversification.

The Pros

Diversity

There were almost 7,000 ETFs traded on the exchanges in 2019.² Among them are large cup ETFs, packages of large corporations with both value and growth potential. Some small cup  ETFs are broadly diversified across business sectors, giving investors an “index” fund of selected companies. There are also real estate inbestment trusts (REITs), which have been packaged into ETFs as well. REITs invest in shopping malls, commercial real estate, hotels, amusement parks and mortgages on commercial property.

Tax Efficiency

Because ETF shares are bought and sold on an exchange, just like stocks, the transactions take place between investors who either own the ETFs – the sellers – or who want to buy the shares – the buyers. So, there is no actual sale of the securities in the ETF package. If there is no such sale, there is no capital gains tax liability incurred. There are other circumstances, however, in which an ETF must sell some shares from its package, thereby resulting in capital gains. Investors are urged to consult with their tax accountants or attorneys to advise on complex tax matters.

Liquidity

The following applies to both domestic and foreign ETFs traded on U.S. markets. Liquidity is a positive aspect of ETFs, meaning an investor can sell his or her holdings with little difficulty and easily retrieve money from the sale.

Volatility

Volatility is reduced in an EFT because it embodies a number of stocks in a specific market sector rather than just one. A single stock may be more likely to decline substantially due to some internal management problem, or because the cost of servicing debt has risen, eroding margins and the bottom line, or from some other misstep or misfortune. Although stocks of an entire sector may suffer a simultaneous price decline, often competitors within the sector may prosper as the bottom line of their business rivals shrink or go red.

Market Orders May be Used

ETFs may be sold through market orders these permit investors to trade ETFs as if they were stocks and provide risk management opportunities and better chances of profitability when day trading. ETFs may also be shorted, meaning they can be sold without ownership at the time of sale and bought back later for delivery to the buyer at a lower price, for a trading profit.

cons of ETFs

While the pros are many, ETFs carry drawbacks too. Among them:

Less Diversification

For some sectors or foreign stocks, investors might be limited to large cup 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 ETF investors.

Intraday Pricing Might Be Overkill

Longer-term investors could have a time horizon of 10 to 15 years, so they may not benefit from the intraday pricing changes. Some investors may trade more due to these lagged swings in hourly price. 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

Costs Could Be Higher

Most people compare trading ETFs with trading other funds, but if you compare ETFs to investing in a specific stock, then the 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 high bid/ask spread. 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 owning a high-yielding stock or group of stocks. The risks associated with owning ETFs are usually lower, but 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.

Leveraged ETF Returns Skewed

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 tracked index. 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 leverage 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.