Before we look at the ETF pros and cons, lets first understand what is an ETF. In the 2020 stock market boom due to Covid-19, hundreds of new ETFs emerged. The retail individual traders jumped on the bandwagon to benefit from the phenomenal rise in ETF trading. The entire world’s stock markets were booming and every tom, dick and harry wanted to put money in stocks.
Investment companies (asset management companies) saw this opportunity to launch a whopping 320 new ETFs in just one single year. As expected, a gazillion investors jumped on board to buy ETFs to get rich quickly.
Pros and Cons of ETFs
- Major ETFs benefits are lower expenses, lower or zero capital gains tax, lower portfolio turnover, day trading opportunity, and possibility of making leveraged investments.
- Severe drawbacks of ETFs on the other hand include higher volatility, higher trading costs, slippage due to illiquid nature, high minimum capital requirement for few ETFs
What is an ETF?
An ETF (Exchange Traded Fund) is an investment instrument which holds a basket of underlying assets – stocks, commodities, bonds. As seen from its name itself, an ETF is listed and traded on stock exchanges (or exchanges for other assets).
An Exchange traded fund generally tracks an index which can be an index well known and commonly followed in the stock market by many ETFs and Mutual funds. Otherwise, it can also be a proprietary index created solely for the purpose of creating and selling this ETF (Fund manager’s marketing tactics).
This is a very important section in unspoken ETF pros and cons, which I have well described further in this article.
What could be the reason? You guessed it right! This is one of the biggest marketing tactics used to sell discretionary portfolio ETF as index tracking ETFs.
More details can be found on an Investopedia article. Let’s rather look at ETF pros and cons. I have split the remaining article into 2 parts, namely, 7 ETF benefits and 10 drawbacks or pitfalls of ETFs.
What are ETF pros and cons?
ETFs are just a reflection of the underlying asset. Exchange traded funds are not considered derivatives. They get the same performance benefits as a basket of stocks, commodities, precious metals, or anything else that the ETF is tracking.
ETF is an easy way to hold a basket of stocks from a sector or an economy or the entire world. I would suggest you carefully go through all the pros and cons of ETFs listed below before you start investing in exchange traded funds.
7 ETF benefits
7 advantages of ETFs to help win over Mutual funds
- Listed and traded on an Exchange
- Basket of stocks, or other asset classes
- ETF NAV vs Price
- Lower expenses: fees and charges
- Lower capital gains tax
- Leveraged and inverse ETFs
- Low turnover ratio for much lower charges
Exchange traded funds have lots of pros and are very popular because of ease of buying and selling, low-cost, tax benefits and a host of other conveniences.
Listed and traded on an Exchange
An exchange traded fund is named so because it is listed on some Exchange. An ETF is generally a very liquid and well-traded instrument. For instance, it is very rare to find no movement in a day in SPY, the ETF which tracks S&P 500.
Amongst all ETF pros and cons, these certainly stands out as huge ETF Advantages. Because ETFs are listed on the exchange, an exchange traded fund gets benefits such as easy sale and purchase throughout the day.
This means you can buy the ETF at your preferred price any your preferred time of the day. Note that exchange traded funds can also be bought and sold on margin, if you have a margin account.
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Basket of stocks, or other asset classes
Even though there are few ETFs which invest in just one particular underlying asset, majority of the exchange traded funds give you an opportunity to invest in a group of asset classes.
An astounding ETF benefit is that with an ETF, you can invest in different stock market sectors, equities, commodities, or geographies.
For example gold ETF gives your portfolio an exposure to Gold. Whereas, the exchange traded fund tracking S&P 500 index gives you exposure to all 500 companies in the S&P 500 index.
There are also several exchange-traded funds that invest in a basket of equities, commodities, and bonds, thereby letting you have a very well Diversified ETF portfolio.
Evaluate ETF list with Diversified ETF Portfolio example using FundSuperMart fund selector. ETF selector. Best Stable ETFs 2021. Mutual Funds and ETFs difference
ETF NAV vs price
The NAV of an ETF is also called as Net Asset Value of any fund, including exchange-traded funds (ETFs).
The primary difference between ETF NAV vs Price is that the Net asset value of an ETF is calculated by summing up the Current Market Price (CMP) of all underlying assets in the ETF, as recorded at market closing time.
Do note that to calculate NAV of ETF vs price of ETF, firstly, the liabilities will have to be deducted, and then the total sum will have to be divided by the number of outstanding shares in the exchange-traded fund.
When comparing the ETF NAV vs its Price, the price of that ETF is simply the exchange quote of that ETF as seen on the exchange on which it is trading.
Within all ETF pros and cons, the ETF NAV vs Price reasoning displays some exclusive ETF Advantages and a few ETF disadvantages over Mutual Funds.
Unlike a mutual fund, since an ETF is listed and traded on the exchange, it’s price changes in real-time based on buyers and sellers interest.
The ETF NAV clearly reflects its price very closely, which is a huge ETF advantage over Mutual funds.
To sum up, the primary reason of why the ETF market price may differ from the ETF NAV is the fact that ETF net asset value depends on the underlying stock’s market value, whereas the price of an ETF is the current market price, quoted and traded on the exchange.
One of the better argument for ETF pros and cons is that because exchange traded fund is listed on an exchange, an investor can easily buy an ETF at either a premium or a discount.
An ETF trading below NAV is called an ETF trading at a discount. This means that the net asset value of the ETF is higher than the price of that exchange traded fund. On the other hand an ETF is trading at a premium when the price of that ETF is above its net asset value.
Lower expenses: fees and charges
Since most of the exchange-traded funds are tracking an index passively, they have this benefit of far lower fees and charges than mutual funds or actively managed ETFs.
A passively managed ETF is a fund which invest in all assets exactly as specified in the tracked index in the same ratio. Whereas, for an actively managed fund, the fund manager decides the stocks he would like to hold based on the ETF’s theme & mission.
The most popular argument between advocates of ETF pros and cons is the point of ETF fees and charges.
Since an ETF generally is a passively managed index-tracking fund, there is no active fund manager required to manage that ETF. Therefore the expenses are kept pretty low. As you can see in the image a few paragraphs above, the expense ratio of SPY is 0.09% only vs any active .
Lower capital gains tax
Most ETFs are passively managed and track some index. So, there is not much buying or selling, also called churning or trade turnover. This gives an ETF the benefit of having lesser realized profits.
Therefore the ETF is not subject to high capital gains tax. It becomes the buyers responsibility to declare the capital gains on selling the ETF.
This should not be called as an ETF advantage but a tactic deployed by the ETF fund managers to distribute the entire amount in the hands of the investor as a part of ETF benefits. This way, the investor pays lower capital gains tax as per his tax bracket.
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Leveraged and inverse ETFs
Turn on the heat – ETFs let you “bet” more by buying double or selling (short trade) the underlying index or asset. For instance TQQQ delivers 3x the performance of underlying Nasdaq index (actually the underlying is QQQ ETF).
Well, leverage can be classified as both pros and cons of ETFs. Let’s look at it from an angle of ETF benefit, while in the ETF downside section, I will give a rock solid reason why Leverage is an ETF drawback.
What is an inverse leveraged etf?
There is another category for profit-hungry investors: Leveraged inverse ETFs (called “ultra short” funds). They rise X-times of the fall of the underlying asset. An inverse ETF that tracks a particular index, and seeks to deliver the inverse of the performance of that index.
Whereas, a 2x (two times) leveraged inverse ETF seeks to deliver double the opposite of that index’s performance.
Leveraged ETFs match the performance of underlying index or asset by X-times. Inverse ETFs do just the opposite; they rise X-times when the underlying asset fallsTweet
In the drawbacks section of pros and cons of ETFs, I have further elaborated on the disadvantages of leveraged ETFs. I suggest you keep a note of that point while reading this point on benefits of leveraged ETFs.
Low turnover ratio for much lower charges
Since most ETFs are passively managed, the fund manager typically runs the ETF as tracking an index. He doesn’t discretely chooses where to invest the fund’s money.
Since he doesn’t keep shuttling the money between equity (buy/sell different stocks) and debt (or cash), the fund does not incur heavy brokerage and other charges associated with buying and selling securities (equity and debt).
What are the disadvantages of ETFs?
So far in this article on ETF pros and cons, you have read about 7 ETF benefits. I will now describe the 10 ETF drawbacks.
ETFs are fantastic instruments but like every financial instrument, ETFs also have some drawbacks. You should be aware of several ETFs negatives before plunging into the ‘BUY this HOTTEST ETF’ game. I suggest you carefully read each of the 10 downsides of ETFs as given below
Disadvantages of ETFs to know before investing all your money in ETFs
- Higher Volatility:
- Higher purchase costs
- Lower liquidity
- Slippage and other trading costs
- Minimum Initial Investment
- US withholding tax
- Shallow index tracking ETFs
- Leveraged ETF risk
- Unreal international exposure
- High risk ETF termed low volatility ETF
Since ETFs are traded in the exchange in real-time, they have higher intraday volatility, resulting in higher daily volatility.
Are ETFs volatile? An exchange traded index tracking fund is generally well diversified. However, because of their nature of intraday trading, their use in arbitrage and hedging, they give rise to lots of buy and sell orders resulting in higher volatility.
According to a study, an increase in one standard deviation in ETF ownership results in 16% increase in daily stock volatility, primarily due to arbitrage activity between ETFs and the underlying stocks.
Some people would argue that “high volatility” is an important point in deciding ETF pros as well as cons. However, here I haven’t discussed how volatility can be an ETF benefit but have only mentioned cons of volatile ETFs.
The simple reason is because this article is intended to describe pros and cons of ETFs for beginners in ETF investing.
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Higher effective buying cost
Investors can buy or sell ETFs like Stocks. This means that every time you purchase an ETF, you bear a transaction fee or brokerage as per your stock broking account plan, which may or may not be equal to the amount of brokerage while purchasing a stock.
Compared to a mutual fund regular investment plan, this could mean you pay a little bit more transaction charges on every purchase.
Lower liquidity – not easy to sell
An ETF is far less liquid than a stock itself. It means that when you wish to buy or sell the ETF, you won’t actually be able to find a buyer or seller easily.
It is because there are not many buyers or sellers who wish to purchase or redeem exchange traded funds. When you compare it with the underlying stocks in that ETF, you will realize that buying or selling that basket of stocks individually is far easier than buying or selling the ETF itself.
CFDs (contract for difference) are super liquid replicas of an asset like stock or stock market index and offer really cheap 24-hour trading. Read the following article for more information.
5. Short selling possibility
Slippage and other “taken for granted” costs
Less liquidity also results in a phenomenon called slippage. Let’s assume you place an order to buy 100 units of ETF for $25.6 per unit. Due to low liquidity, you won’t be able to find a seller who’s selling at $25.6. You might be able to buy 35 units @ $25.8, next 30 units @ $26.1, and the remaining units @ $26.3, thereby effectively bringing up your purchase price sometimes by higher by 2%.
So if you want to diversify across sectors or geographies, you can select a sectoral ETF or a country-specific ETF. However, if you want to invest in a ETF that in turn invest in a select set of stocks, I would suggest you rather buy the stocks directly.
Minimum initial investment
Since exchange traded funds hold a basket of stuff, purchasing one unit of an ETF is sometimes really difficult. It is not always the case but it is not uncommon either.
An ETF can have a minimum investment imposed. You can buy just 1 unit of a $25 stock but perhaps the ETF you fancy has imposed a minimum initial investment of at least $1000.
US withholding tax
All ETFs traded in the stock market are subject to a withholding tax imposed by the US tax department, whether you are a US resident or not.
The tax is applicable not just on the dividend received, but also on redemption of proceeds in case of the ETF holder’s demise. This could also easily be a point of disagreement between people arguing between tax falling under ETF pros or cons.
Just because withholding tax will be charged on dividend distribution, it doesn’t stop you from investing in dividend paying high return ETFs. After all, the average annual ETF dividend by most high return ETFs is just between 1 to 2%.
Note: the applicable tax is nothing short of between 30 to 40% on the entire dividend amount or the entire ETF investment amount.
Shallow index tracking
ETFs, specifically index tracking ETFs are sometimes have as many ETF pros as they have cons. Since this is a list of disadvantages, I will reveal a secret. There are lots of index-tracking ETFs that do not really track a proper index.
What I mean is that sometimes the ETF fund manager or ETF asset management company registers a proprietary index, created using a discretionary portfolio, on a stock exchange and then buys stocks in that index.
Their intention is to create a portfolio that might be able to beat the major stock market index. Now they want to find people who can invest in their discretionary portfolio. So they create a mutual fund structure around that and try to sell that mutual fund through mutual fund distribution companies and mutual fund advisors
|ETF Name||NAV||exchange||Underlying Index|
|SPDRÂ® Kensho Clean Power ETF (CNRG)||80.7||NYSE||S&P Kensho Clean Power TR USD|
|Invesco Global Clean Energy ETF (PBD)||24.43||NYSE||WilderHill NewEnergy GLB Innovate TR USD|
|Renaissance IPO ETF (IPO)||55.3||NYSE||Renaissance IPO TR USD|
|iShares Global Clean Energy ETF (ICLN)||20.7||NASDAQ||S&P Global Clean Energy NR USD|
|Invesco DWA Healthcare Momentum ETF (PTH)||144.3||NASDAQ||Dorsey Wright Hlthcr Tech Ldrs TR USD|
|Global X MSCI China Consumer Disc ETF (CHIQ)||29.2||NYSE||MSCI China Csm Dctnr 10/50 NR USD|
|Principal Healthcare Innovators Index ETF (BTEC)||50.8||NASDAQ||NASDAQ US Health Care Innovators TR USD|
|Direxion Russell 1000Â® Growth Over Value ETF (RWGV)||100||NYSE||Russell 1000 Gr/Val 150/50 Net Sprd USD|
But when it comes to an exchange traded fund, there are no such ETF investment advisors. One of the drawbacks of index tracking ETFs is that the asset management company now creates an ETF instrument around that proprietary index, just for purpose of calling the ETF as an index tracking ETF.
As you know, an index tracking ETF is far easier to sell because any naive investor woukd easily fall into the trap of the index tracking ETF seemingly being safe to invest and well diversified.
Leveraged ETF risk
As mentioned in the ETF benefits section, Leverage can fall equally under ETF advantages as well as when we speak about ETF disadvantages. My reason of describing leveraged ETF pros and cons, and advising against investing in a Leveraged ETF is due to the fact the Leverage is a double edged sword. If you gain 2x, then in bad times, you lose 2x as well.
Most ETFs invest in large cap companies. Some invest in different geographies, different market sectors or different asset classes. However one common thing across all is that they mostly invest in fast moving stocks.
If you leverage on a popular liquid stock when its rising, you can actually capture 2x or 3x the underlying asset’s move.
Disadvantages of leveraged ETFs
The bad point is that leverage can be seriously harmful if not used properly. A TQQQ like 3x leveraged ETF has more pros than cons but in a downturn, it can have a serious drawback. It can cause lot of pain when the market suddenly falls like it did in the spring of 2020.
They use derivatives to track an index but with 2 or 3 times the exposure, which would result in a huge downside during economic recession. Oftentimes, the improper use of derivatives and weak understanding of ETFs pros and cons by beginner investors can result in huges losses.
No real international exposure
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Especially on the international ETFs part, you have to carefully evaluate the ETF pros and cons. Even they call themselves ETFs with international exposure, they still invest primarily in the US market.
There is no harm in that but your global diversification options then go for a toss. If you intend to not limit yourself to US or country specific funds, you need to purchase between 2 to 5 ETFs for a broader global market and asset class exposure.
Some so-called global exchange traded funds have an unreported ETF pitfall – they do not have real global exposure. For instance, one of the biggest global ETFs iShares MSCI ACWI ETF (ACWI) tracks the MSCI All Country World Index.
High risk ETF wrongly termed as low volatility ETF
Investors prefer low-volatility ETF strategies while they are beating the market only because they are supposed to be less risky than even an average stock with a promise of an average return.
Investors who focus on price stability while ignoring fundamental growth stability may find that they have embraced riskier stocks than they intendedBen Snider from Goldman Sachs
Some sector specific ETFs board the bus when the sector is growing at far better levels than its usual performance. This kind of a fund, even if it is investing in a low volatility sector might choose low quality stocks just because those stocks are the shining stars in that sector, no matter how fundamentally weak they are.
Therefore you need to keep all ETF pros and cons in mind and be aware of such ETFs. You should try to avoid those is you are not an active ETF investor but rather believe in ETF buy and hold strategy.
You are better off selecting your preferred stocks and buying them direct if you wish to not invest in a risky stock at all.
Or if you are too confused and instead would prefer an automated advisory solution like robo advisor that invests in multiple asset classes automatically for you, you can read the following article.
Advantages of robo advisors. Why robo advisors are bad? Learn Robo advisor Pros and cons. Are Robo advisors profitable? Learn why not to use a robo advisor?
My primary reason of writing this article was to help investors be aware of the biggest issues with ETFs as well as tell them about unspoken ETF pros and cons. I sincerely wanted to enlighten the readers with the most appealing ETF advantages, and the most uncommon and secret ETF disadvantages.
Especially those exchange traded fund risks and ETF pros and cons that are not highlighted by your investment advisor or the Asset management company. The only place where they are legally bound to mention that is in the ~170 page ETF offer document which nobody reads before investing.
Thank you for reading this article. I have written several other such Investment related articles.
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