More people are investing in exchange-traded funds (ETFs) since their introduction in the ’90s. According to Statista, the ETF global value had surpassed $10 trillion by 2021.
Additionally, the ETFs in the market rose from 276 to almost 8,600 between 2003 and 2021. From individuals to institutions, different types of investors use ETFs to achieve their financial goals. However, any smart trader must consider the pros and cons of ETFs before buying the funds.
What are ETFs?
ETFs are pooled securities that function like mutual funds. They monitor specific indexes, commodities, or sectors. However, you can buy or sell ETFs on the stock exchange during market hours.
An ETF’s price fluctuates throughout the day as traders buy and sell shares. On the other hand, mutual funds only trade once daily when markets close. Likewise, ETFs are more liquid and economical than mutual funds. You can classify ETFs as:
- Equity ETFs: By tracking basket stocks, equity ETFs allow you to invest in hundreds of companies with only one trade. Furthermore, equity ETFs can monitor businesses of different sizes or assets from specific countries. You could also use the assets to identify high-performing sectors during a particular period.
- Currency ETFs: They can either track basket currencies or one currency such as the American dollar. You can own currency ETFs directly, using derivatives, or through a combination of the two methods. These funds replicate market performance by holding cash deposits of the underlying currency or utilizing futures contracts.
- Specialty ETFs: These funds focus on specific investment strategies. But although they offer high returns, specialty ETFs require investors to conduct due diligence owing to their high risk. The funds fall into two categories. For starters, inverse funds benefit from the loss of a target index. That way, you can profit from a market decline without having to short-sell. Another category is leveraged ETFs that use debt to boost returns.
- Bond ETFs: Although capital gains come annually, investors receive monthly dividends. Unlike bonds, these fixed-income ETFs offer more liquidity, transparency, and accessibility to secondary markets.
- Commodity ETFs: They track the movement of commodities like oil, gold, and silver. Rather than buying physical assets, investors own contracts supported by the commodity.
Pros of investing in ETFs
You can only reap maximum returns when you understand the pros and cons of ETFs. Here’s how ETFs beat other investments.
- Diversification
An exchange-traded fund carries tens or hundreds of companies. You have the option of different industries, investment strategies, and company sizes. Moreover, the fund can track the returns of one country or a group of nations.
By diversifying your portfolio, ETFs prevent overdependence on one company or industry. That way, you don’t lose everything in the event of a market swing. Another benefit is flexibility. In addition to trading during regular hours, ETF investors can wager on declining markets by short-selling ETFs.
- Lower Fees
There are several reasons why ETFs cost less than mutual funds. First off, most ETFs are passively-administered, reducing operational expenses. The active management of mutual funds requires investors to pay for researchers, accountants, and equity experts.
In contrast, passively-managed ETFs don’t require analysts because the fund follows a benchmark. ETFs also have fewer administrative burdens. Thanks to intraday trading, ETF issuers aren’t involved in every transaction by the investor. The issuer’s main role is the creation and redemption of new shares.
- Tax Advantages
ETFs have more tax benefits than mutual funds. For starters, mutual fund holders incur more capital gains tax owing to the frequency of their trades. Conversely, ETFs have creation units that facilitate the collective buying and selling of assets.
At the same time, ETFs have fewer taxable events because of their passive nature. Note that ETF dividends don’t get any tax privileges since they’re recorded as received.
- Reduced Volatility
Exchange-traded funds have lower volatility because they comprise several stocks instead of one. On the hand, a single stock is more prone to substantial declines because of internal management issues or high debt servicing costs.
What’s more, ETFs offer risk management opportunities such as market, stop-loss, and limit orders.
Cons of investing in ETFs
No investment is foolproof. Here are some disadvantages of ETF investments.
- Extra Costs
ETFs might be more affordable than mutual funds, but investors still incur some costs. Like stocks, buying and selling ETFs invites trading fees. These costs depend on your brokerage firm and type of ETF.
Moreover, the funds might duplicate low-volume indexes as more niche ETFs emerge, increasing the bid/ask spread. In such cases, buying the actual stock might offer a better deal.
- Lower Dividends
Although some ETFs pay dividends, the returns may be lower than high-yielding stocks. ETFs might be less risky, but you could earn more when you take a chance on stocks.
- Limited Diversification in Some Cases
Certain sectors limit investors to large-cap assets because of narrow equity groups. An investor who cannot access mid or small-capitalization companies has fewer growth opportunities.
Additionally, ETFs may not be ideal for hands-on investors. You may avoid certain asset classes because of personal values and sustainability issues. For example, some people don’t invest in businesses that sell tobacco or meat products. As such, using ETFs to meet specific investment goals can be challenging when the ETF tracks companies you don’t like.
Exchange-traded funds may have some challenges, but they’re still preferred for passive income. Even so, study the ETF and related holdings to understand its performance. Additionally, calculate the fees and commissions to know whether the investment is viable.
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