Exchange-traded funds (ETFs) were created to combine the best characteristics of both stocks and mutual funds into a combined investment structure. They'll ideally leave out some of the less desirable ones. They have some drawbacks, however. No investment vehicle is perfect for everyone.
Key Takeaways
- ETFs offer easy access to a diversified portfolio of assets.
- They're traded on stock exchanges throughout the trading day, providing investors with the flexibility to buy or sell shares at market prices.
- ETFs typically have lower expense ratios compared to mutual funds because they're more passively managed.
- They disclose their holdings daily, allowing investors to see the underlying assets and make informed investment decisions.
- There are a few downsides to ETFs to be mindful of as well.
Understanding ETFs
ETFs have characteristics of both mutual funds and individual stocks. Their primary purpose is to provide investors with a convenient way to achieve diversification. ETFs typically track a specific index, such as a stock market index. The underlying principle of an ETF is to replicate the performance of this chosen index rather than actively manage its holdings.
ETFs are mandated to disclose their holdings daily. This grants investors visibility into the assets held within the fund. ETFs are also more passively managed compared to other forms of investments such as mutual funds. This has its advantages although there are some downsides as well.
ETFs are popular and include more diversified offerings as time goes by. The U.S. Securities and Exchange Commission approved 11 new spot market bitcoin ETFs in January 2024 to be listed on the NYSE Arca, Cboe BZX, and Nasdaq exchanges. They're the first spot market bitcoinETFs ever to be offered.
ETFs can be used to target specific sectors, themes, or asset classes. They can also be used to cover different types of markets such as equities, fixed-income securities, commodities, or alternative investments.
Most ETFs are professionally managed by SEC-registered investment advisors.
Advantages of ETFs
Tax efficiency and liquidity are some common advantages that ETFs have over mutual funds, but the list doesn't stop there.
Tax Efficiency
ETFs can minimize capital gains distributions through the creation and redemption processes. This strategy is not available for mutual funds.
Liquidity
ETFs are traded on stock exchanges at market prices throughout the trading day. Investors can buy or sell shares when the market opens or throughout the day. Mutual funds typically trade at their net asset value (NAV) at the end of the trading day so traders have to wait until the market has closed before the mutual fund can be repriced and traded.
Lower Expenses
ETFs are usually passively managed. The portfolio manager sets the fund and then has a greater hands-off approach to managing it compared to a mutual fund manager. ETFs generally have lower expense ratios compared to mutual funds because the ETF manager is spending less time overseeing the fund but this is only as true as the level of passiveness of the fund manager.
Transparency
ETFs usually have to provide a daily disclosure of their holdings so investors are rarely left in the dark about what the ETF holds. This transparency can be very important to some investors. It can help them make smarter decisions based on what they're holding. Mutual funds typically disclose their holdings less frequently and this makes it more difficult for investors to gauge exactly what is in their portfolios.
Diversification
ETFs are designed to offer diversification by tracking a particular index or asset class. An investor can access a broad range of assets without having to worry about buying a lot of different stocks or security products. Investing in an ETF can reduce risk compared to buying just a single stock. Be mindful that the underlying components of an ETF may still be correlated, however. This is especially the case if they're all related to the same industry, such as an ETF that invests in commercial real estate.
No Minimums
Many ETFs have no minimum investment requirements so they're widely accessible to investors, especially those who are just starting without a lot of upfront capital to invest. This accessibility allows new investors to test the waters in a low-stakes environment. There may be fewer requirements to meet because there are no minimums and this can allow a new investor to more easily get started.
Authorized participants in an ETF can buy and redeem shares straight from the ETF but they can only do this in very large chunks. The SEC cites 50,000 ETF shares as an example.
Drawbacks to ETFs
ETFs come with a wide range of benefits but there are also some downsides to consider.
Intraday price volatility and bid-ask spreads may occur because ETFs can be traded during the day. This gives investors flexibility in trading their ETF exactly when they want but it also creates some price instability. Everyone else can buy or sell whenever they want as well.
Some ETFs can be complex and carry higher risks, particularly leveraged and inverse ETFs. This requires a thorough understanding of their strategies. Leveraged ETFs simply magnify the potential return of another ETF, posing a greater upside but also a greater downside to an investor. Inverse ETFs attempt to take the opposite position of something and bet on the inverse of that index to be successful.
ETFs are typically passively managed. They aim to replicate specific indexes. ETFs may make a little less money as a result because their goal isn't necessarily to maximize profits.
Examples of Widely-Traded ETFs
Some ETFs are more heavily traded than others. Those that top the list include:
- The SPDR S&P 500 (SPY) is the most widely known ETF. It tracks the S&P 500 Index.
- iShares Russell 2000 (IWM) tracks the Russell 2000 small-cap index.
- Invesco QQQ (QQQ) tracks the Nasdaq 100.
- The SPDR Dow Jones Industrial Average (DIA) tracks the Dow Jones Industrial Average which includes 30 stocks.
How Do ETFs Offer Liquidity to Investors?
ETFs trade on stock exchanges like individual stocks. They're bought and sold at market prices throughout the trading day. This liquidity provides investors with the ability to enter or exit their positions quickly because there's a ready market of buyers and sellers.
What Are the Benefits of ETFs for Long-Term Investors?
Long-term investors can benefit from ETFs in several ways. Their cost efficiency and low expense ratios can contribute to better returns over the years. The tax advantages of ETFs, such as minimizing capital gains distributions, also make them a tax-efficient choice for long-term investing.
Are There Any Potential Downsides to ETFs?
ETFs can be subject to intraday price volatility because they can be traded during the day. Some ETFs can be complex and carry high risks, particularly leveraged and inverse funds. ETFs are also usually passively managed so they may not be suitable for investors who prefer active management with higher earning targets.
What Is Tracking Error in ETFs?
Tracking error represents the deviation between an ETF's performance and the performance of its benchmark index. This discrepancy can occur due to factors such as management fees, dividend reinvestment, or the bid-ask spread.
Tracking errors are typically small but they're important for investors to consider when evaluating an ETF's performance relative to its benchmark. Investors aren't necessarily trying to maximize their return when they're investing in ETFs. They're trying to get a performance as close to a specific index as possible.
The Bottom Line
ETFs offer numerous advantages including diversification, liquidity, and lower expenses compared to many mutual funds. They can also help minimize capital gains taxes. But these benefits can be offset by some downsides that include potentially lower returns with higher intraday volatility.
