The Pros and Cons of ETFs
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Summary:
Exchange-traded funds can be great investments, as they often contain diverse securities, come at a low cost, and allow you to immediately reinvest your dividends. However, depending on the ETF you invest in, you may find that you receive fewer dividend funds and have less diverse securities than you previously realized. Because of this balance between benefits and drawbacks, ETFs aren’t a great fit for every investor.
Exchange-traded funds (ETFs) are baskets of securities traded as one security on a stock exchange. As of 2021, there were over 8,552 ETFs trading worldwide, allowing investors to own baskets of stocks that track an index, represent an industry, track a commodity, or represent a foreign market.
ETFs are commonly recommended to new investors or investors looking for more diversity and less risk. However, that doesn’t mean ETFs are all fantastic investments. Keep reading to learn about the different kinds of ETFs, the benefits and drawbacks of this investment, and whether ETFs are right for your investment portfolio.
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What is an ETF?
An exchange-traded fund (ETF) is a collection of securities that trades like a stock on the stock market. Similar to individual stocks, an ETF has a ticker symbol, which you use to buy and sell the fund like a stock. However, rather than being one individual company’s stock, an ETF is a group of stocks or other securities.
ETFs are especially helpful for new investors, as the group of stocks helps stabilize the volatility some stocks experience. But before you invest in an ETF, you first need to know what your investment strategy is. Fortunately, if you don’t know what your strategy is, you can ask a brokerage firm for assistance.
Where did ETFs come from?
In the early 20th century, the only investors were rich guys or institutions buying individual stocks. In 1924, Massachusetts Financial Services (MFS) started the Massachusetts Investors Trust. This was followed in 1929 by the Wellington Fund, which owned individual stocks and bonds. It was the first of many actively managed mutual funds.
Someone needed to invent an investment vehicle for those investors who simply wanted to own the S&P 500 and get similar performance to the index. In 1976, Vanguard offered the first of the index mutual funds that tracked this index, which quickly became popular because the fees were low.
In 1993, the S&P 500 SPDR became the first U.S.-listed exchange-traded fund, which tracked the index and traded on a stock exchange. As the idea grew, so did the choices available, allowing investors to choose from over 8,500 ETFs as of 2021.
Learn about specific ETFs
To learn more about some of the more popular index funds, take a look at some of our articles comparing:
What are the different kinds of ETFs?
While most of the ETFs we’ll discuss in this piece track stock market indexes (known as an index tracker fund), that’s not the only kind of ETF. You can purchase ETFs that focus on specific commodities — such as oil, precious metals, or cryptocurrency — or even delve into foreign securities. However, you can also purchase bond ETFs, which contain a basket of bonds instead of securities.
You may prefer more actively managed ETFs, which are closer to mutual funds. While these funds tend to cost more, you may like having a team of managers who buy and sell for you, especially when the stock market is volatile. On the other hand, for a more strategic investment strategy, you can look at leveraged ETFs. These funds use borrowed money (leverage) to hopefully enhance returns.
What is your investment strategy?
Many people see the stock market as a great place to invest, but that doesn’t mean every person invests the same way. Before investing in the stock market, you need to determine how involved you want to be in your portfolio and what your risk tolerance is.
- Involvement. Do you prefer checking a stock’s performance every day? Or would you rather check once a week? When thinking about stock “involvement,” consider how much time you want to put into stock research and monitoring.
- Risk tolerance. How much do you worry about stock volatility? Are you comfortable recognizing when you should sell a stock or hold and wait for the market to right itself? The stock market is constantly fluctuating, and some stocks can be more volatile than others. If you’re not comfortable with the potential of losing money before a stock rises again, you may prefer ETFs over individual stocks.
Examples of investment strategies
To get a better idea of what your investment objectives may be, consider the following scenarios.
- Beth lives and breathes stocks. She wants to find the next Amazon or Apple, so she sits up at night looking over reports and crunches data to find the ideal stock. She usually buys individual stocks.
- Eric wants to be involved in the stock market, but not as the major focus of his life. He doesn’t want to decide when to buy or sell individual stocks, so he hires a brokerage firm and invests in a combination of individual stocks and index funds.
- Christine wants in on the stock market but doesn’t want to risk much. She knows that she wants to put some of her money in gold— but doesn’t want to hold physical bars. Instead, she buys ETFs in the gold industry, which are comprised of multiple companies involved in different processes throughout the gold market. She could also buy an ETF tracking the price of the metal.
Pro Tip
If you are new to stock market investing, index funds are a great place to start. However, you don’t have to stick with ETFs exclusively. A mutual fund may also be a great investment option, as you’ll likely find more actively managed mutual funds.
Pros and cons of ETFs
Though ETFs are generally less volatile than individual stocks, this type of investment isn’t immune from stock market risks. Before investing in ETFs, make sure you fully understand the pros and cons of this investment.
Pros of ETFs explained
Diversification
Because an ETF contains a basket of securities, your investment portfolio is immediately more diverse. You can also diversify your investment portfolio by looking into different kinds of ETFs rather than just those that track market indexes.
Lower costs and expense ratio
Since ETFs tend to be passively managed, their expense ratios are often much lower than more actively managed investments. Mutual funds, on the other hand, require significantly more fees since they are so actively managed. ETFs that track an index generally have minimal fees.
Similar to trading stocks
Even though you’re buying multiple securities with ETFs, you can trade them with the same liquidity as you can stocks. For instance, you can sell ETFs short, buy them on margin, or even trade futures and options. Unlike mutual funds (which are priced at the close of the trading day), ETFs are traded during the day and experience price fluctuations.
Favorable tax treatment
Because ETFs are passively managed, they tend to be more tax efficient than mutual funds and realize fewer capital gains. Actively managed mutual funds create a taxable event when they buy shares of stock and then sell them.
Gains generate a capital gains distribution, which is taxable to the investor. A passively managed index fund, on the other hand, rarely if ever sells stocks within the ETF, so there is no taxable event until the investor chooses to sell their ETF shares.
Reinvested dividends
Many stocks and some ETFs pay dividends. But rather than taking those funds, it makes sense to put this money back to work instead of collecting small sums of money. Open-ended ETFs are set up to easily reinvest dividends immediately, whereas mutual funds have different reinvestment timelines.
Smaller chance of trading below net asset value
Since ETFs trade throughout the day, they have a smaller chance of trading higher or lower than their actual value. Even if the ETF’s price is significantly different, arbitrage will bring the price back to the appropriate value.
Cons of ETFs explained
Potential for less diversification
Spreading your investments across many stocks can reduce risk, but not if they are all similar stocks. Owning an ETF tracking a broad index like the S&P 500 means you are diversified across many stocks in many industries.
However, when you own an ETF tracking a specific industry or sector, you often own fewer stocks. The problems affecting one often affect them as a group because of their similarity.
Active management costs money
If you prefer to have someone actively manage your ETF, those savings from avoiding a mutual fund disappear. You’ll also have to pay a management fee for ETFs, which you don’t have to pay for individual stocks.
Lower dividend yields
When you buy an ETF representing a sector or industry, you are buying a collection of stocks. Some pay higher dividends than others. The dividend yield of the ETF is the average of what the group of stocks is paying. If getting the highest dividend yield was your priority, you would do better selecting and buying a few individual stocks.
Doing it yourself is sometimes better
The ETF structure gives you a collection of stocks, which is a good thing. You might be investing in a sector comprised of stocks that trade at high volumes, meaning the bid-offer spread is small. However, the ETF is a separate security with its own bid-offer spread. This can be different, especially if it tracks a low-volume index.
Leverage distorts results
Leveraged ETFs use debt and financial derivatives to multiply any potential wins or losses. The longer the leveraged ETF is held, the more varied the ETF’s returns will be compared to the individual’s securities. And if the individual security dips, those losses could amplify significantly in a leveraged ETF.
What do you need to know about ETFs?
If there are over 8,500 global ETFs listed, what factors should influence your decision on which ones to buy?
- Expense ratios. While all index funds have fees, unmanaged ETFs should have lower expense ratios than actively managed mutual funds. However, different types of ETFs may have higher fees, such as leveraged ETFs.
- Stocks inside. Suppose you wanted to invest in health services. You do your research and discover that there are 60 ETFs that track this sector. What makes them different? One factor is top holdings. If the fund is actively managed, their favorite stocks influence performance.
FAQs
Are ETFs a good investment?
An ETF can be a good investment because a basket of stocks will prevent you from experiencing heavy volatility. However, whether an ETF is a good investment for you will depend on your investment goals and strategy.
If you’re more risk-averse, then ETFs are highly recommended, as buying one ties your performance to the index or asset where it’s focused. Owning several ETFs also builds a more diversified portfolio, which further protects you from volatility.
Are ETFs safer than stocks?
This depends on what you mean by “safer.” Since one ETF is comprised of multiple stocks, ETFs are more diverse and less volatile than individual stocks. That being said, you can still lose money with ETFs, so you aren’t safe from potential loss.
Can you lose money in ETFs?
Yes, you can absolutely lose money in ETFs. An ETF is a basket of securities, but these securities still rise and fall in value, just like stocks. If your ETF tracks a dropping market, then you can lose money.
Are ETFs good for beginners?
Yes, ETFs are a great place for people who want exposure to the stock market but feel uncomfortable picking individual stocks.
Key Takeaways
- Exchange-traded funds (ETFs) are a good choice for people who want to be invested in the stock market but don’t want to be involved in picking individual stocks.
- Buying an ETF tracking a broad market index is a good way to get diversification with a single investment.
- In addition to index ETFs, you can also purchase ETFs that track specific industries or commodities, such as precious metals or cryptocurrency.
- While ETFs tend to cost less than mutual funds and offer more diversity than individual stocks, this is not true of all ETFs.
- Make sure to carefully inspect the ETF you’d like to invest in, as it may cost more and promise fewer returns than the individual stock.
BS
Bryce Sanders is president of Perceptive Business Solutions Inc. He provides HNW client acquisition training for the financial services industry. His book, “Captivating the Wealthy Investor” is available on Amazon. Bryce spent twenty years with a major financial services firm as a successful financial advisor. He has been published in 40+ metro market editions of American City Business Journals, Accountingweb, NAIFA’s Advisor Today, The Register, LifeHealthPro, Round the Table, the Financial Times site Financial Advisor IQ and Horsesmouth.com.
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