One of the common types of a pooled fund or investment fund and a particular type of securities that can be bought and sold or traded in an open market is called an exchange-traded fund or ETF. Take note that it is called a “fund” because it pools or combines money from different investors and investment in different securities, and it is also called “exchange-traded” because it can be bought and sold or traded in stock exchanges and through traditional and online-enabled brokers similar to the equities or stocks of publicly-traded companies.
Investing in ETFs provides investors with the benefits of investing in both pooled funds and securities. They also have defining features that make them more optimal compared to other options. However, because of their characteristics as pooled funds and tradable investments, they can also demonstrate some of the drawbacks inherent to all pooled funds and other traditional securities like stocks, bonds, and commodities. Deciding to invest in an exchange-traded fund requires understanding its advantages and disadvantages.
Pros of ETFs: Notable Advantages of Exchange-Traded Fund
The main selling point of ETFs is that they allow investors to invest in different securities or assets in a single transaction. Furthermore, because they are tradable, they can be readily bought and sold in an open market, specifically in stock exchanges through brokers. The different selection of ETFs also caters to different investment and risk profiles. An investor can choose ETFs for either investing or trading activities. Investing in ETFs can also be part of a risk management strategy. Below are the specific pros of ETFs:
1. Investment Diversification
One of the foremost advantages of investing in an exchange-traded fund is that it provides an easier avenue for investment diversification. A particular ETF represents a basket of different securities and asset classes like stocks, bonds, currencies, and derivatives. This spreads an investment across different companies or securities and assets. Take note that this is similar to the advantages of other pooled funds like mutual funds and unit investment trusts.
2. Convenience and Flexibility
ETFs lessen the need for investors to research and select which securities or assets to invest in. A particular basket includes securities preselected by fund managers based on predefined investment goals and objectives. An investor would only need to select an ETF with goals and objectives that are aligned with his or her goals and objectives. Furthermore, unlike other pooled funds, ETFs can be bought and sold on stock exchanges like stocks.
3. Expansive Selection of Funds
Furthermore, related to diversification and convenience advantages, there are different ETFs that are structured based on different and specific goals and objectives. There are ETFs focusing on stocks or domains like technology and artificial intelligence. Some focus on bonds and cash equivalents to appeal to risk-averse investors. Others are composed of different types of securities and assets for a more balanced investment portfolio.
4. More Cost-Effective Investing
Another advantage of an exchange-traded fund is that it often has a lower expense ratio than an actively managed mutual fund. It is also more cost-effective to invest in ETFs or other pooled funds compared to purchasing individual stocks, bonds, or other securities from a broker. Most ETFs are also considered more tax-efficient than other pooled funds because they are structured in a way that minimizes the distribution of capital gains.
Cons of ETFs: Main Disadvantages of Exchange-Traded Fund
The aforementioned advantages of ETFs are not always absolute. Some of the benefits are confined to a particular ETF. This also means that there are ETFs that are more disadvantageous than the others. It is also worth mentioning that these tradable pooled investments share some of the disadvantages inherent to other pooled funds and most securities on top of their unique drawbacks and limitations. Not all ETFs are the same or share the same beneficial characteristics. Below are the specific disadvantages of ETFs:
1. Susceptible to Certain Risks
All investments have risks. ETFs have different levels of risk depending on their composition. Those that include equities are prone to risks inherent to stocks while those that are focused on debentures are inclined to share the risks of bonds. Furthermore, because they are tradeable and also have trading volume, they are also susceptible to market risk which comes from either the day-to-day fluctuations in prices or macroeconomic factors.
2. Associated Investment Costs
It is also important to underscore the fact that there are certain costs associated with investing in ETFs. These include trade commissions or the fee each time an investor buys or sells a particular exchange-traded fund, operating expense and management fee that is associated with operating and managing the fund, the bid and ask spread that represents the difference between the highest bid price and lowest ask price, and varied tax obligations.
3. Liquidity Issues Likelihood
Tradeable securities or assets are often considered liquid. However, in certain cases, this is still dependent on the trading volume. Some ETFs have low trading volume. This can lead to either barring investors from selling them as quickly as possible or wider bid-ask spreads that further hinder trading transactions. ETFs with low trading volumes include those with niche market exposures, complex strategies, or recently launched ones.
4. Variable Benefits and Risks
It is also important to reiterate that another one of the main disadvantages of an exchange-traded fund is that it can have defining benefits and risks that are incomparable to other ETFs. Not all ETFs are created equal. Those that are focused on a particular industry give limited diversification advantages and greater industry-specific risk exposure. ETFs based on an active investing principle also have higher operational expenses and management fees.
Takeaways: Deciding When to Invest in Exchange-Traded Funds
Most investors are encouraged to invest in an exchange-traded fund or even accumulate different exchange-traded funds in their portfolio. Remember that one of the main advantages of ETFs is that they provide investors with a more convenient route toward investment diversification with minimal cost than investing in individual securities or assets. However, like in any other investment decision, it is first important for an interested investor to understand his or her goals and objectives, as well as his or her risk profile, and ensure that such are aligned with the predefined investment goals and objectives of a particular exchange-traded fund.
