ETFs Benefits and Drawbacks
Answering the Question Why Exchange-Traded Funds Are So Popular
By reviewing advantages and disadvantages of ETFs, investors may get a better idea whether this type of investment vehicle is right for them.
Investors can obtain exposure to an index by investing in exchange-traded funds, or ETFs for short. ETF fans can be found within a wide spectrum of investors, from individual to institutional, due to a number of advantages that these types of securities offer. Of course, it would be wise to remember that ETFs are not the “one-size-fit-all” solution for all investors and in any market segment.
Benefits of ETFs
One of the benefits of ETFs that usually tops the list is diversification. With ETFs, this is accomplished with one transaction only. If an investor wants diversified exposure to equities, it can be instantly gained by buying ETFs that focus on certain geographic regions, or industries/sectors, or market capitalizations, or different investment styles, such as growth or value.
Although an ETF essentially consists of an entire portfolio of securities, it still trades as a stock on an exchange, it can be bought, bought on margin, sold, and sold short. In addition, ETFs trade during normal market hours and are priced continuously, just like any other stock. Many ETFs even have futures and options contracts attached to them, which offers hedging and risk management options to investors.
One important feature of ETFs is that all holdings in a portfolio underlying an ETF are completely transparent. Investors are advised daily what comprises the ETF, which is different from mutual funds, for example, the holdings of which are published only from time to time and at a portfolio manager’s discretion.
ETFs are also very cost effective for investors because there are no “loads” usually associated with mutual funds. This is because ETFs are managed passively; that is, they simply mirror an underlying index, instead of a portfolio manager picking and choosing which stock to include in a managed portfolio. As a result of such management style, most ETFs typically have low expense ratios.
Drawbacks of ETFs
On many exchanges around the world, actively traded ETFs often track only a collection of stocks with large market capitalizations. In other words, in many countries there are no ETFs containing mid or low market capitalization stocks. Note, however, that this is not the case in the U.S., where there is a large selection of ETFs actively mirroring indices regardless of market capitalization of stocks included in them.
One of the issues with ETFs is that their trading volumes are not large and the bid and ask spreads are often quite wide. For example, on the U.S. exchanges, many ETFs mirror certain sectors or foreign indices. As these are rarely actively traded, this often results in a higher than usual expense ratios (sometimes close to one percent), compared to managed portfolios. In other words, investors would profit more to invest directly in an actively managed mutual fund, particularly if an investor is contemplating a large investment.
Source: International Investments, Fifth Edition, by Bruno Solnik and Dennis McLeavey, Copyright 2004.
