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 of ETFs will help new and current holders navigate risk and reward.

Advantages

There are numerous advantages of mutual funds and ETFs. Below are a few:

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.

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.

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, 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.

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 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 2 times 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%

A double-leveraged ETF does not always mean you will see double the return of the index. The table above 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.

The Bottom Line
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. Furthermore, the tax implications associated with ETFs need to be considered when deciding if ETFs are for you.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI Emerging Mkts

    Learn more about the PowerShares FTSE RAFI Emerging Markets ETF, a fundamentally weighted fund that tracks emerging market equities.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares Cali AMT-Free Muni Bond

    Learn more about the iShares California AMT-Free Municipal Bond exchange-traded fund, a popular tax-advantaged ETF that dominates its category.
  3. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P Emerging Markets Dividend

    Learn more about the SDPR S&P Emerging Markets Dividend Fund, a yield-focused exchange-traded fund tracking global emerging economies.
  4. Mutual Funds & ETFs

    ETF Analysis: First Trust Dow Jones Global Sel Div

    Find out about the First Trust Dow Jones Global Select Dividend Index Fund, and learn detailed information about characteristics and suitability of the fund.
  5. Mutual Funds & ETFs

    ETF Analysis: U.S 12 Month Natural Gas

    Learn about the United States 12 Month Natural Gas Fund, an exchange-traded fund that invests in 12-month futures contracts for natural gas.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Floating Rate Bond

    Explore detailed analysis and information of the iShares Floating Rate Bond ETF, and learn how to use this ETF as a defense against rising interest rates.
  7. Mutual Funds & ETFs

    ETF Analysis: ProShares UltraPro Short S&P500

    Find out information about the ProShares UltraPro Short S&P 500 exchange-traded fund, and learn detailed analysis of its characteristics and suitability.
  8. Mutual Funds & ETFs

    ETF Analysis: SPDR Barclays Investment Grd Fl Rt

    Learn more about the SPDR Barclays Investment Grade Floating Rate Fund, which tracks an index of highly rated floating debt securities.
  9. Mutual Funds & ETFs

    ETF Analysis: ALPS Medical Breakthroughs

    Learn more about a unique and innovative exchange-traded fund (ETF) in the biotechnology industry: the ALPS Medical Breakthroughs Fund.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares US Healthcare

    Learn about the iShares U.S. Healthcare exchange-traded fund, which invests in a wide range of health care providers, hospitals and home care facilities.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Brazil, Russia, India And China ...

    An acronym for the economies of Brazil, Russia, India and China ...
  4. Series 6

    A securities license entitling the holder to register as a limited ...
  5. Passive Income

    Earnings an individual derives from a rental property, limited ...
  6. Qualified Longevity Annuity Contract

    A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity ...
RELATED FAQS
  1. Can mutual funds outperform savings accounts?

    A mutual fund can – and should – outperform a savings account. In most cases, it should not even be a close race. Savings ... Read Full Answer >>
  2. Can mutual funds invest in private companies?

    Mutual funds can invest in private companies, which may come as a surprise to many investors. It is rare for a fund to have ... Read Full Answer >>
  3. Why is my 401(k) not FDIC-Insured?

    401(k) plans are not FDIC-insured because they are typically composed of investments rather than deposits. The Federal Deposit ... Read Full Answer >>
  4. How are non-qualified variable annuities taxed?

    Non-qualified variable annuities are tax-deferred investment vehicles with a unique tax structure. After-tax money is deposited ... Read Full Answer >>
  5. Why are IRA, Roth IRAs and 401(k) contributions limited?

    Contributions to IRA, Roth IRA, 401(k) and other retirement savings plans are limited by the IRS to prevent the very wealthy ... Read Full Answer >>
  6. What are the best ways to use your 401(k) without a penalty?

    The best way to use your 401(k) retirement savings account is to take normal distributions after you reach retirement age. ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!