Exchange-traded funds (ETFs) began in the late 1980s and quickly gained popularity as investors started looking for alternatives to mutual funds. Investors, both institutional and individual, could see the benefit of holding a specific group of stocks with lower management fees and higher intraday price visibility. On the other hand, with lower management of the fund, the burden was placed on the investor to select a proper investment. Identifying the advantages and disadvantages will help new and current holders navigate risk and reward. Tutorial: Exchange-Traded Funds

Advantages
Diversification
One ETF can give exposure to a group of equities, market segments or styles. In comparison to a stock, the ETF can track a broader range of stocks or even attempt to mimic the returns of a country or a group of countries. For example, you could focus on Brazil, Russia, India and China in a BRIC ETF. Mutual funds can be diversified as well but the ETF has lower fees and trades more like an equity investment. (For more on mutual funds, see Advantages Of Mutual Funds.)

Advertisement - Article continues below.

Lower Fees Compared to Managed Funds
ETFs, which are passively managed, have much lower expense ratios compared to other managed funds. A mutual fund's expense ratio is usually higher due to costs such as: a management fee, shareholder accounting expenses at the fund level, service fees like marketing, paying a board of directors, and load fees for sale and distribution.

Trades Like a Stock
Although the ETF might give the holder the benefits of diversification it still trades like a stock.

  • ETFs can be purchased on margin and sold short.
  • They trade at a price that is updated throughout the day. An open-ended mutual fund is priced at the end of the day at the net asset value.
  • ETFs also allow you to manage risk by trading futures and option just like a stock.
  • Because they trade like a stock you can quickly look up the approximate daily change of a commodity or sector with the ticker symbol of a tracking ETF. Many stock websites also have better interfaces for manipulating charts than commodity websites and even provide applications for your mobile devices.
Dividends Are Reinvested Immediately
The dividends of the companies in an open-ended ETF are reinvested immediately, but the timing can vary for index mutual funds. It should be noted that dividends in unit investment trust ETFs are not automatically reinvested, thus creating a dividend drag.

Capital Gains Tax Exposure Is Limited
ETFs can be more tax-efficient than mutual funds because most of the tax on capital gains is paid on sale, and completely up to the investor. Even if the ETF sells or buys shares while attempting to mimic the basket of shares it is tracking. This is because the capital gains from in-kind transfers, seen in ETFs, do not result in a tax charge, and therefore can be expected to be lower compared to 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 taxable as a capital gain. 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 lower chance of having ETF prices that are higher or lower than the actual value. 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. This is different than closed-ended index funds because ETFs trade based on supply and demand and market makers will capture price discrepancy profits.

Disadvantages
May Be Limited to Larger Companies
In some countries, investors might be limited to large-cap stocks due to a narrow group of stocks in the market index. Only including larger stocks will limit the available exposure to mid- and small-cap companies. This 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 hours could induce a trade where pricing at the end of the day could keep irrational fears from distorting an investment objective.

Bid-Ask Spread Can Be Large
As more niche ETFs are created you might actually find an investment in a low volume index. This could result in a high bid/ask spread. You might find a better price investing in the actual stocks (usually large institutional investors) or maybe even a managed fund. (To learn more about this spread, see The Basics Of The Bid-Ask Spread.)

Costs Could Actually Be Higher
Most people compare trading ETFs with trading other pools of stocks such as mutual funds, but if you compare ETFs to investing in a specific stock the costs are higher. The actual commission paid to the broker might be the same, but there is no management fee for a stock.

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 is usually lower, but if an investor can take on the risk the dividend yields can be much higher. For example you can pick the stock with the highest dividend yield, but ETFs track a broader market so the overall yield will average out to be lower.

Leveraged ETF Returns
Certain ETFs, which are double or triple leveraged, could result in losing more than double or triple the tracked index. These types of speculative investments need to be carefully evaluated. If the ETF is held for greater than one day the actual loss could be more than double or triple. 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, as shown in the example below, 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. In the example, you can see the ETF returns correctly tracking 2X the return of natural gas on a daily basis, but the overall return over eight periods does not (-2.3% vs. 0%). The ease of investing in leveraged ETFs could increase investments by individuals with less understanding. These investors may have never attempted to own a double or triple leveraged investment, but ETFs make it quite easy.

Double-Leveraged Returns

Period

 Double Leveraged ETF

 ETF % Change

 Natural Gas Price

 Nat. Gas % Change
1

 $10.00

--

 $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%

 $6.50

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%
Figure 1: The Downside of Double-Leveraged ETFs
A double-leveraged ETF does not always mean you will see double the return of the index. Figure 1 does not take into account any fees. The double-leveraged ETF ends up down 2.28% when the price of natural gas has not changed.

Fund Comparison Conclusion
ETFs are used by a wide variety of investors in order to build a portfolio or gain exposure to specific sectors. There are many advantages especially compared to other managed funds such as mutual funds. They are like stocks in the way that they trade but can also be compared to more broad investments even entire indexes in their price movements. There are also disadvantages to watch out for before placing an order to purchase these sometimes tricky investments.



For more related reading, also check out How To Reduce Taxes On ETF Gains.