What are the benefits and limitations of investing in ETFs? MintGenie explains (2024)

FAQs

What are the advantages and disadvantages of investing in ETFs? ›

In addition, ETFs tend to have much lower expense ratios compared to actively managed funds, can be more tax-efficient, and offer the option to immediately reinvest dividends. Still, unique risks can arise from holding ETFs as well as tax considerations, depending on the type of ETF.

Positive aspects of ETFs

The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.

Because ETFs generally track market indexes, turnover is usually low, resulting in lower capital gains taxes. ETFs also benefit from the ability to transfer securities in and out of the portfolio in the most tax-efficient manner, known as the in-kind creation and redemption process.

ETF trading risk

Spreads can vary over time as well, being small one day and wide the next. What's worse, an ETF's liquidity can be superficial: The ETF may trade one penny wide for the first 100 shares, but to sell 10,000 shares quickly, you might have to pay a quarter spread.

ETFs often generate fewer capital gains for investors than mutual funds. This is partly because so many of them are passively managed and don't change their holdings that often.

ETFs have some structural advantages relative to mutual funds but it's important to remember that ETFs have risks like all investments. Five of the key ETF risks to consider include: market risk, tracking error, liquidity, sector concentration, and single-stock concentration.

There are many ways an ETF can stray from its intended index. That tracking error can be a cost to investors. Indexes do not hold cash but ETFs do, so a certain amount of tracking error in an ETF is expected. Fund managers generally hold some cash in a fund to pay administrative expenses and management fees.

The low investment threshold for most ETFs makes it easy for a beginner to implement a basic asset allocation strategy that matches their investment time horizon and risk tolerance. For example, young investors might be 100% invested in equity ETFs when they are in their 20s.

By minimizing capital gains distributions, ETF tax efficiency lets investors defer tax bills until they sell shares, preserving more capital for market investment and potential compounded returns over time.

What is a disadvantage of an ETF quizlet? ›

The disadvantage is that ETFs must be purchased from brokers for a fee. Moreover, investors may incur a bid-ask spread when purchasing an ETF.

Not all ETFs offer the criteria for short-term trading, which includes high liquidity, cost efficiency, and price transparency. To maintain liquidity, traders should avoid ETFs that have a high percentage of off-exchange trades.

Advantages and disadvantages of ETFs

Investing in ETFs helps to mitigate unsystematic risks due to its passive investment strategy. It also lowers one's overall investment risk. It greatly helps with portfolio diversification. With the limited role of fund managers, ETF investments are comparatively cost-effective.

Leveraged ETFs use various financial instruments such as futures, options and swaps to achieve their leverage. These instruments have associated costs, including transaction costs, bid/ask spreads and management fees. These costs can eat into the returns of the ETF and contribute to its decay.

Thanks to their lower costs and ability to diversify a portfolio, ETFs are considered low-risk investments. That's not to say ETFs are not risk-free. They can be tax-inefficient, generate high trading fees, and have low liquidity.

Liquidity Risk

Not all ETFs have a large asset base or high trading volume. If you find yourself in a fund that has a large bid-ask spread and low volume you could run into problems with selling your shares. That pricing inefficiency could cost you more money and greater losses.

ETFs typically track a specific market index, sector, commodity, or other asset class, exposing investors to a range of securities in a single investment. Their benefits include liquidity, lower expenses than mutual funds, diversification, and tax advantages.

You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all.