Understanding the Pros and Cons of ETFs

October 8, 2021

Since the first security of its kind was created in the early 1990s, exchange-traded funds (ETFs) have been among the most popular investment vehicles for investors from all walks of life.

Need proof?

As of 2018, there were nearly $4.7 trillion in assets under management in ETFs worldwide. Considering the fact that the global market capitalization of all publicly-traded companies is estimated to be in the range of $80 trillion, up from $25 trilling in the last decade, ETFs account for no small slice of the pie.

And their popularity is understandable. They come with the diversity of a managed fund and the ease of stock investing—quite an appealing combination for investors who don’t want to add new layers of complication to managing their portfolio.

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An exchange-traded fund is essentially a collection of assets — such as stocks, bonds, commodities and other types of securities — that tracks a given index or idea. Once packaged up this way, the ETF is a marketable security that can easily be bought and sold on a stock exchange and has an associated price that rises and falls based on the prices of the ETF’s underlying assets.

ETFs can track just about anything, the S&P 500, the price of oil, the value of agricultural commodities and more.

However, as is the case with all investment vehicles, ETFs come with their advantages and disadvantages. And before investing in one, it’s important to weigh all the information to make sure it’s the right strategy for your investment goals.

ETFs Trade Like Stocks

The pros: One of the biggest benefits of investing in equities is their liquidity. In other words, it’s easy to buy and sell stocks during trading hours, and retrieve money from the market. And because ETFs trade like stocks, they have the same feature.

There are other benefits to the ETF’s stock-like nature, as well: you can place advanced orders on your purchases, such as limit orders and stop losses; you can trade futures and options; and you can short sell them.

Plus, like a stock, an ETF’s price is updated throughout the day. (This as opposed to mutual funds—the popular alternative to ETFs—which are priced and purchased after the market closes, once the net asset value has been determined.)

The cons: Like stocks, each ETF trade comes with a broker’s commission. If you trade actively, those commission fees could start eating into your overall returns. And also like stocks, not all ETFs are inherently liquid. It’s important to make sure whichever ETF you’re looking at trades at a high enough volume to be easily bought or sold.

ETFs and Diversification

The pros: ETFs, like other types of funds, give you exposure to a certain sector or market through a basket of underlying assets. And like other funds, there are ETFs for just about everything, from niche markets all the way up to the national economies.

And because of the inherent diversification, ETFs can protect investors against market volatility. You’re much more likely to see swings in the price of an individual stock—which can result from any number of factors (poor management decisions, slowing sales, a poor quarterly report, etc.)—than you are in an ETF.

(This is of course dependent on the type of ETF you invest in. A niche or small sector ETF could experience more volatility than one that tracks a broader market, like the S&P 500.)

The cons: It’s worth noting that some experts argue most ETFs don’t offer enough diversification. In certain sectors or markets, for instance, ETFs may be limited to large-cap stocks… which could in turn limit investors to growth opportunities in small- and mid-cap companies.

And while not a con per se, there’s another risk factor worth mentioning: if you’re invested in an ETF that follows a particular sector, your ETF is susceptible to the risks of that sector—such as if the market is untested, or if there’s an economic downturn.

ETFs and Fees

The pros and cons: There’s a hot debate in the investing community about whether ETF fees should be considered costly. On the one hand, since ETFs are passively managed, they tend to have much lower management and other service fees than mutual funds (which are actively managed).

However, when compared to buying individual stocks (for which there are no management fees), ETFs are costlier.

There are many good reasons for the popularity of exchange-traded funds among investors large and small alike. Their stock-like features combined with their easy diversification and passive management make an attractive investment vehicle for obvious reasons.

But it’s just as important to be aware of their disadvantages, so that you can make an educated decision on whether they’re right for your particular investment goals.

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