Exchange-traded funds (ETFs) were introduced in the 1990s and have continued to grow in popularity. Some estimates say that there are a few thousand ETFs available for investors today. As with any investment, you should fully understand what they are, how they work, and the advantages and disadvantages before adding them to your investment portfolio.
ETFs are similar to index mutual funds. Index mutual funds and ETFs try to duplicate the holdings within a specific index or benchmark in an attempt to replicate the performance of that index. The main difference between ETFs and mutual funds (including index mutual funds) is that ETFs are traded and priced throughout the trading day like stocks. Mutual funds are only priced once per day – at the end of the trading day when the market closes.
ETF’s have been known to be relatively tax efficient and inexpensive when compared to active mutual funds. Since an ETF’s holdings are designed to track an index, they only change when the holdings of the index changes. Most indexes do not change their holdings very often. This generally results in lower trading costs and lower tax costs. In addition, ETFs usually have lower annual expenses because they do not have as much overhead associated with having a portfolio manager selecting securities for the portfolio.
As ETFs become more popular, new indexes are being developed for ETFs to track. As a result, some ETFs are beginning to look more like active mutual funds with higher costs, higher expenses, and lower tax efficiency.
If you are considering ETFs for your portfolio, here are some main advantages and disadvantages to consider:
• ETFs trade like stocks. Therefore, they can be bought and sold throughout the trading day as the price fluctuates and can be bought on margin, sold short, or traded using stop orders and limit orders.
• Unlike mutual funds, ETFs do not have to hold cash or buy and sell securities to pay fund investors when a redemption is requested.
• An ETF’s annual expenses and trading costs are usually lower than non-index mutual funds.
• ETFs typically have lower annual taxable distributions because they trade less frequently than mutual funds.
• ETFs may allow you to diversify your portfolio into additional sectors of the market such as commodities.
• ETFs may not be cost effective if you are Dollar Cost Averaging or making repeated purchases over time because of the commissions associated with purchasing ETFs. Commissions for ETFs are typically the same as those for purchasing stocks.
• From a timing perspective, selling an EFT when you want to or need to may be difficult if the ETF is a thinly traded issue or if the market is experiencing high volatility. This is also true when selling stocks.
• Some ETFs may not track a widely accepted index, which may result in higher costs and higher risk.