Exchange-traded funds, or ETFs, have been around for a few decades. They have grown in popularity over the years and are currently one of the most popular ways to invest in stocks. ETFs offer several advantages that make them attractive to many investors. They’re diversified, easy to trade, and inexpensive. However, there are also some disadvantages that you should be aware of before investing in ETFs. In this article, we’ll go through both sides so you can decide for yourself if an ETF is the right for your investment needs!
Advantages of Investing in ETFs
One of the biggest advantages of investing in ETFs is diversification. Diversification is a technique that reduces risk by allocating money over various types of investments, such as stocks and bonds. For example, when you invest in an ETF, it’s made up of multiple different stock holdings across many industries. This helps balance potential losses if one sector does poorly due to market forces outside its control. In addition, adding more investment products into your portfolio can help offset some price volatility since their performance isn’t always correlated with each other.
Trades like stocks:
ETFs follow a trading mechanism that is very similar to common stock. That means you can buy and sell them any time of day. In addition, many brokers offer low commissions for trading ETFs. When you invest in ETFs, you also have access to real-time quotes, so you know exactly how much your investment is worth. ETFs can also be traded on margin and short sold, providing the investor additional flexibility. They can be bought at a price that is updated throughout the day. Investing in ETFs allows you to take advantage of derivatives like stock trading by using futures and options.
Immediately Reinvested Dividends:
ETFs often provide a way for investors to reinvest dividends, which can be beneficial if you have no interest in selling your shares. Most brokerages will automatically reinvest the cash dividend on the pay out day by buying more of that particular ETF. Investors prefer this method rather than waiting until they receive their quarterly or annual statement and then deciding what action(s) they want to take with those funds. This means investors don’t have any market risk from withholding taxes when there are share buybacks since all dividends are passed through without tax consequences.
Limited Capital Gains Tax:
Capital gains taxes are only charged when you sell the ETF for a profit. That means if your investment is held long enough to grow without ever being sold, then capital gains tax isn’t an issue.
Disadvantages of Investing in ETFs
Not all stocks or bonds may be included in an ETF. An ETF tracks the performance of a market index, whether it is the DOW Jones Industrial Average or the S&P 500. It’s important to know which indexes the particular fund tracks so that you don’t buy one with high fees and poor performance. This also makes it harder to find specific investments since there tend to be fewer different types of funds available than traditional mutual funds. E.g., Let’s say an ETF tracks the S&P 500 index. But since the fund cannot track the index in its entirety, it uses base stocks to track the index. In doing so, the fund may or may not include some of your favorite shares or stocks that you believe have a bright future. It is tough to find an ETF with the right investments. Some investors would argue that having only a small number of different ETFs available is an advantage. The fewer investment options you have, the easier it should be to choose one that closely matches your investment goals.
Not all ETFs can perfectly match their benchmark’s performance. Due to tracking errors, some mutual funds and ETFs may not accurately track their indexes, leading long-term investors to make poor choices about where their money should be allocated.
Higher trading fees:
Since ETFs trade like regular stocks, you’ll often have to pay a commission when buying and selling them. The average ETF has an expense ratio of 0.20%, which may not seem like much until you realize it’s on top of any commissions your broker charges. A flat fee of $30 or more per trade is standard with most discount brokers, so the total cost can be very high if you make frequent trades.
Lower Dividend Yields:
The average dividend yield of the S&P 500 is about two percent. That’s more than most other investment opportunities like bonds, but it pales compared to some high-yield stocks. Investing in ETFs can be challenging for investors who are used to receiving quarterly dividends. So, they may react negatively when their new investments don’t provide the same income level.
Leveraged and inverse ETFs:
Leveraged funds often appeal to people with higher risk tolerances since these securities tend to produce more significant returns over time. However, even though you’re expecting big payouts, substantial risks are involved if your expectations aren’t met or you lose money due to high market volatility. Many investors invest in inverse ETFs to protect against market volatility. Inverse ETFs use derivatives rather than cash to try and make a profit. These investments can be helpful for hedging purposes, but they come with risks, too.
Investing in ETFs might be a wise choice if you want to diversify your portfolio but do not want to take on the hassles of investing in mutual funds. However, this doesn’t mean you should blindly invest in ETFs. In the stock market, no asset is entirely risk-free, and that includes ETFs. Make sure you place your bets wisely. Happy Investing!