Exchanged-traded funds – ETFs – have come onto the investing scene by storm. They typically have good expense ratios and often come with tax benefits, but there can be downsides.
Exchange-traded funds (ETFs) have become insanely popular over the last two decades. Since the ETF craze began in 1993, the U.S. now has more than 1,700 of the funds, and worldwide the funds have more than $5 trillion under management. So what’s driven the funds’ popularity and what might investors be missing in their rush to invest in them?
Here are the pros and cons of investing in ETFs.
The pros of investing in ETFs
The positives of buying ETFs are many, and ETFs solve a lot of problems for investors, so it’s little wonder that they’ve become so popular. (Here’s a quick refresher on what an ETF is.)
Quick and easy exposure to an investing theme
This might be the biggest positive, especially for professional investors, but really anyone who wants to buy one security, plug it into their portfolio, and have exposure to almost any investing theme. Want midsize European stocks, large dividend payers, small companies? Check, check, check.
So you get your investing theme, but you have to pay up for that, right? No, ETFs are often cheap, especially the most popular. The median fee for the top 20 funds is 0.07%, or $7 annually per $10,000 invested, according to Marketwatch. And expense ratios for ETFs tend to be cheaper than for mutual funds.
ETFs usually have at least a few dozen companies (and sometimes hundreds, as is the case with S&P 500 index ETFs), so you’re not overly exposed to any one company, and if there’s a company you like that the fund is underinvested in, you can always increase your allocation to that company. You can get exposure to almost any sector, company size, investing style, or country.
ETFs Require less knowledge
You know a sector is about to do well, but which company do you buy? ETFs get you in the game quickly without requiring you to understand all the advantages of each individual company. In fact, this is one of the major advantages of the S&P 500 index fund, which superinvestor Warren Buffett has touted for years. So ETFs can be a perfect fit for novice investors.
ETFs are more flexible than mutual funds. ETFs trade during the regular trading day just like a stock, but unlike mutual funds, which only trade after the market closes. Investors can also short sell stocks using ETFs, wagering on a decline in a stock or market.
ETFs also offer tax advantages over mutual funds. ETFs usually produce lower capital-gains taxes than mutual funds, because of how they’re constructed. ETFs only incur capital-gains taxes when they’re sold, while mutual funds pass those gains (and therefore the tax liabilities) on to investors every year over the life of their holding. So investors are on the hook for taxes on gains even if they haven’t actually sold the mutual fund.
So with these advantages it’s not hard to see why ETFs have become so popular, but that doesn’t mean they are always the best option.
The cons of investing in ETFs
There really aren’t a lot of downsides to investing in ETFs, but investors should be aware of them anyway. Sometimes ETFs aren’t always as good as they claim to be.
Low cost — but not always
Yes, ETFs are generally cheaper than mutual funds, but not always. For example, Fidelity Investments introduced two no-fee index mutual funds in August 2018. It’s hard to get cheaper than that. Yes, many index ETFs are only marginally more expensive — a few dollars a year per $10,000 invested — so let’s not be too picky. But sometimes ETFs can be out-and-out pricey, especially if they’re serving a more niche sector — African small caps, anyone? — or they’re a smaller fund.
While the largest ETFs are heavily traded, many ETFs are small and focused on a narrow niche. This limited appeal almost guarantees that an ETF trades at a lower volume. And lower volume means that you’ll likely pay more for the fund than otherwise.
Lower upside than individual stocks
ETFs provide diversification, smoothing out investing returns and usually providing a good but not great return. In any fund, some stocks perform well and others less well, meaning that highly knowledgeable investors could likely do better than the fund’s return by buying only the stocks that perform above the average. For most investors, however, buying a diversified fund works out better.
Less diversified than they appear
An ETF’s holdings are less diversified than it may seem and they’re often fairly concentrated in the top 10 stocks, meaning the ETF’s performance relies most on only these top holdings. Plus, these top 10 are often high-volume large-cap companies that appear in many other ETFs, so buying multiple ETFs may not get you as much diversification as you first think.
So those are the pros and cons of investing in ETFs, but don’t get too worried over the negatives. The many advantages of ETFs have made them incredibly popular, and ETFs form the basis of many “passive” investing strategies that have tended to outperform most professionals for years on end.