ETFs – Pros and Cons

ETF is short for Exchange Traded Funds, or investment vehicles that invest in a basket of stocks.  The difference between an ETF and a mutual fund is that an ETF trades like a stock on a regular stock exchange, and its share price is calculated several times per second, based on the value of its underlying securities.

There are several types of ETFs, including basic index and stock ETFs, which track indexes or other baskets of stocks.  There are also bond ETFs, which invest in bonds.  There are also commodity and currency ETFs which track precious metals and currency prices.  Basically, no matter what type of investment you are looking for, there is an ETF for that.

The Pros of ETFs

ETFs are extremely popular right now because of their low costs and tax efficiency.  Because most ETFs track indexes or simple stock portfolios, there is little management involved.  That means that expenses are low, and costs to investors can be kept low.  Also, because of this feature of little trading, there is little tax implication from owning an ETF.  Unlike mutual funds, which turnover (or trade) over 100% of their portfolio every year, ETFs that track indexes have very few trades each year.  The only tax implications would be from dividend distributions.

Investors also like ETFs because they trade like a stock on a regular market.  This differs from mutual funds, which only trade once a day, after the market closes.  Because they trade throughout the day, investors can be very selective on price and timing.

The Cons of ETFs

The biggest cons of ETFs is that they don’t as closely match their underlying securities as investors are led to believe.  On average, most ETFs miss their target index return by 1.25%, which is significant when returns average around 4-8% on average.

The deviation from the index increases in foreign market ETFs, and the most with leveraged ETFs.  Many investors also don’t realize that leveraged ETFs typically only seek to mimic the daily price movement, not the long term return.  So, deviation can occur by holding these ETFs for a long period of time.

One Response to ETFs – Pros and Cons

  1. Short and sweet, I like it! I use ETFs mainly to trade options, approximately 2-3 month long trades due the deviation. I traded one ETF that I actually bought that was SUPPOSE to track the VIX and sure enough it dropped 50% in one day. Talk about panic!