Advantages and disadvantages of ETFs
Many different types of investments are available to individual investors. These range from highly risky, speculative investments such as futures contracts to very safe but low-yielding options, like certificates of deposit (CDs). A necessary type that has become increasingly popular over the past few years is exchange-traded funds (ETFs). ETFs can track an index or group of assets and buy and sell on a stock market.
Here’s why you should trade ETFs:
One advantage these securities have over other investment types is their liquidity, which increases day by day. They can be purchased or sold extremely quickly compared to other investments because they are so easily tradable. Also, ETFs are typically less expensive than mutual fund shares. They charge lower fees because they do not require active management. However, in some cases, they are more expensive than index funds that do not require active management.
ETFs are built to track specific indexes, which means that they have some degree of tracking error. This happens when there is a difference between what an ETF records as its value and what its underlying assets are really worth. Tracking error can be a major disadvantage for investors, but only if the tracking error is significant. However, even a slight difference can add up to a large amount over time. Investors need to look at their specific ETFs before investing in them to ensure there isn’t too much tracking error.
Mutual funds are available in a wide range of varieties, even within the same asset class. ETFs offer investors diversification at a more simplified level of investment options. Many mutual funds have hundreds or thousands of different stocks; diversifying the portfolio individually is not possible. However, ETFs typically cover one or two indexes, and risk can be spread across many securities.
What factors should you consider?
ETFs are taxed much differently than mutual funds. Unlike mutual funds, ETFs are traded throughout the day. An investor who buys at the end of one trading day pays a long-term capital gains tax on any price increase between when they purchased it and sold it, even if that holding period is just one day. On the other hand, mutual fund investors only pay taxes once a year when they sell their shares, by which time the assets may have increased or decreased significantly in value. Thus ETFs tend to be more attractive investments for short-term traders rather than long-term investors.
ETFs may be traded at a premium
Another disadvantage is that ETFs sometimes trade at a premium or discount to the value of their underlying assets. For example, if an investor paid $100 for one share of an ETF with securities valued at $98 and sold it later when those securities’ value rose to $102, they would lose money on the investment because the price of the shares had increased faster than the value of its underlying assets. However, long-term investors can avoid this problem by simply holding onto the ETF until they sell it after one year.
ETFs also have higher trading costs because of their continuous trading feature. In addition, brokers’ commissions may not apply because ETFs are traded on stock markets, which means they have commission fees similar to those charged by other companies who buy and sell securities on the market. The annual expense ratios of many ETFs are lower than those of comparable mutual funds, but some ETFs do charge higher expenses.
Trading costs in perspective
ETFs are still much less expensive to trade than stocks. Mutual funds can also be costly when investors or their financial advisers trade them too often, called trading abuse. An investor who pays off the capital gains accrued by his mutual fund each year does not pay any taxes on those gains. However, there is typically a fee for trading mutual funds that consider the amount of money that underlies that specific security. The average expense ratio charged by exchange-traded index funds was 55% lower than the average stock mutual fund in 2010, putting ETFs at an advantage here as well.