scorecardresearchWhat are the Advantages and Disadvantages of ETFs?

What are the Advantages and Disadvantages of ETFs?

Updated: 12 Apr 2022, 10:20 AM IST
TL;DR.

Exchange traded funds (ETFs) are just like other mutual funds but they are different to the extent that they are traded on stock markets. Let us explore its features and shortcomings.

An ETF is a basket of securities that are traded on the stock exchanges.

An ETF is a basket of securities that are traded on the stock exchanges.

Exchange-traded funds, or ETFs, are mutual funds that are exchanged on a stock exchange which follow a commodity, an index or a portfolio of assets, such as an index fund. They have risen in popularity among investors searching for alternatives to mutual funds since their debut in 1993. 

These products, which consisted of a basket of assets meant to replicate an index and offered minimal management costs and more intraday price transparency, were appealing to both institutions and consumers.

However, no investment is without shortcomings, and ETFs are no exception, with drawbacks varying from minor dividends to wide bid-ask gaps. Understanding the benefits and drawbacks of ETFs can assist investors in navigating the risks and rewards of these quarter-century-old securities and evaluating if they sound right for their portfolios.

Advantages of Exchange Traded Funds

Diversification

A single exchange-traded fund can provide exposure to a variety of stocks, market sectors, or styles. An ETF can follow a larger variety of equities or even try to replicate the results of a nation or a group of nations.

Liquidity

ETFs are exchanged on a stock exchange and may be traded at any time during the day, not only at the end of the day. When volatility is high, this can be a significant benefit.

Lower cost ratios

ETFs, which are passively managed, have considerably lower cost ratios than mutual funds, which are often actively managed. Management fees, shareholder accounting expenditures at the fund level, service fees such as marketing, paying a board of directors, and load fees for selling and distribution can be the reasons for higher cost ratios of mutual funds.

Immediately reinvested dividends

Dividends are instantly reinvested in an open-ended ETF, but the exact date for reinvestment in index mutual funds might fluctuate. However, there is one exception: dividends paid by unit investment trust ETFs are not automatically reinvested, resulting in a dividend drag.

Lower discount or Premium in price

ETFs can save you money on taxes compared to mutual funds. ETFs (and index funds) have lower capital gains than actively managed mutual funds since they are passively managed portfolios.

READ MORE: What are the types of Exchange Traded Funds? A primer

Disadvantages of Exchange Traded Funds

Diversification is limited

Due to a small number of securities in the market index, investors may be limited to large-cap companies in particular sectors or international stocks. Due to a lack of exposure to mid- and small-cap firms, ETF investors may miss out on significant growth possibilities.

Intraday pricing could be excessive

Longer-term investors may not gain from intraday pricing fluctuations since their time horizon is 10 to 15 years. Because of the delayed fluctuations in hourly prices, some investors may trade more. A large movement in price over a few hours might trigger a transaction, with pricing at the end of the day preventing irrational concerns from distorting an investment goal.

Dividend yields have dropped

Dividend-paying ETFs exist, but their yields may not be as high as holding a high-yielding stock or group of companies. The dangers of holding ETFs are typically smaller, but if an investor is willing to accept the risk, stock dividend payouts may be considerably greater. While you can choose the stock with the greatest dividend yield, ETFs track a larger market, resulting in a lower total yield.

Costs could be greater

Most people compare trading ETFs to trading other funds, however the costs are higher when comparing ETFs to investing in a single company. Although the actual commission paid to the broker may be the same, a stock does not have a management charge. In addition, when more specialised ETFs emerge, they are more likely to track a low-volume index. A wide bid/ask spread might occur as a result of this. You might be able to get a better deal by investing in genuine equities.

Returns on leveraged ETFs are skewed

A leveraged ETF is a fund that boosts the returns of an underlying index by using financial derivatives and debt. Certain ETFs that are double or triple leveraged can lose more than double or triple the value of the underlying index. These kinds of risky investments must be thoroughly scrutinised. The actual loss might quickly grow if the ETF is held for a long period.

A wide range of investors use ETFs to create portfolios or get exposure to certain industries. They trade similarly to stocks, but their price fluctuations may be compared to more wide assets, or even whole indexes. They have a number of benefits over other managed funds, such as mutual funds.

However, there are certain drawbacks to be aware of before placing an order to buy an ETF. When it comes to dividends and diversity, your options may be more restricted. Therefore while evaluating whether or not ETFs are right for you, you must examine all the factors associated with it.

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First Published: 12 Apr 2022, 10:20 AM IST