Benefits and Drawbacks of Investing in ETFs

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Contributor, Benzinga
July 14, 2023

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Investing in Exchange-Traded Funds (ETFs) has become increasingly popular in recent years. But are they really worth your investment? While ETFs offer a range of benefits, there are also some drawbacks to consider before diving in.

The world of investing can be complex and overwhelming, with countless options available to grow your wealth. ETFs have gained traction as a popular investment vehicle due to their simplicity and diversification benefits. However, it's important to weigh the pros and cons before making any investment decisions.

If you're considering investing in ETFs, it's crucial to understand both the advantages and disadvantages they present. This article will explore the benefits and drawbacks of investing in ETFs, helping you make an informed decision about whether they are the right investment choice for you.

The same holds true when it comes to exchange-traded funds (ETFs). These products hold baskets of different assets and trade on exchanges like stocks. 

As an investment, ETFs have provided investors with increased flexibility and versatility while carrying risks, including having been at the epicenter of a few financial meltdowns. 

If you're interested in learning about the benefits and drawbacks of investing in ETFs from both perspectives, this article is for you. 

What is an ETF?

An ETF is an exchange-traded financial instrument that tracks the value of an underlying basket of assets, which can be anything from stocks, bonds, commodities or currencies. 

When you buy a share of an ETF, you receive proportional exposure to all its underlying assets. ETFs trade on exchanges like stocks do, with their share price updated throughout the day. 

Like mutual funds, ETFs also have a net asset value (NAV), which represents the value of all assets held by the ETF, minus liabilities and divided by shares outstanding.

Benefits of Investing in ETFs

Overall, ETFs have provided investors with numerous advantages compared to individual stocks and mutual funds. These include:

Liquidity

Like stocks, ETFs trade on an exchange. Because the ETF process is supported by an Authorized Participant (AP) who is responsible for creating/redeeming ETF units to meet investor demand, ETF investors enjoy high liquidity. Even ETFs with low trading volume can be safe to buy as ultimately the liquidity is determined by the underlying asset. Buying an ETF is as simple as searching the ticker and setting a limit order in the middle of the current bid-ask spread. 

Affordability 

ETFs charge an expense ratio, which is a percentage fee deducted on an annual basis by the fund manager to pay for operational costs (trading, marketing, accounting) and to turn a profit. Compared to mutual funds, ETFs, especially the passively managed index variants tend to charge a very low expense ratio. Some ETFs charge as little as 0.03%. 

Tax Efficiency

When mutual funds sell assets at a profit, they accrue capital gains and pay them out to shareholders annually. With ETFs, the creation/redemption mechanism and how shares trade on the secondary market greatly minimizes distributions. 

Transparency

Mutual fund investors can be left in the dark when it comes to a fund’s holdings. These funds report their holdings on a quarterly basis. Thus, there is the risk of your mutual fund's holdings or strategy drastically changing from what you originally invested in. In comparison, most ETF managers update their holdings daily, which can easily be found online on the ETF's webpage. 

Versatility

Because ETFs trade on exchanges, they've developed a booming derivatives market. Investors can trade options on many of the most popular ETFs on the market today, unlike with mutual funds. The ETF structure also allows for more creative and exotic products, such as leveraged, inverse or buffer ETFs. 

Drawbacks of Investing in ETFs

However, investing in ETFs isn't a risk-free endeavor. Like all investment products, ETFs have drawbacks and disadvantages. Some of the common ones include:

Liquidation and Closure

ETFs can and have closed. Reasons for an ETF closure include being unable to attain sufficient assets under management (AUM) or the underlying asset losing all its value. Examples of this include the 2018 "Volmageddon" incident, where some short VIX ETFs suffered catastrophic losses and were liquidated. A recent example was the liquidation of many Russian equity ETFs after the country's stock market collapsed because of its invasion of Ukraine. If an ETF closes, investors will be paid out the ETF's final NAV, which can be at a loss or force capital gains, creating a taxable event. 

NAV Divergence

ETFs have two prices. The first is the share price, which is determined by trading in the secondary market. The second, more accurate price is the fund's NAV. During periods of great market volatility, the share price of an ETF can occasionally trade at a discount or premium relative to its NAV. While the ETF creation process usually arbitrages any discrepancies away quickly, it isn't always effective. An example of this risk occurred during the March 2020 COVID-19 crash when numerous bond ETFs traded at a steep discount from their NAV.

Manager Risk

Actively managed ETFs that attempt to outperform a benchmark are never guaranteed to succeed. With these ETFs, success is dependent on the ETF manager's strategy, which can change over time and become ineffective. An ETF that has historically outperformed is never guaranteed to do so in the future. 

Market Risk

Passive ETFs that follow an index will tank when the market does. For example, an S&P 500 ETF will lose value if the underlying S&P 500 index experiences a crash. The ETF manager cannot do anything to hedge, stop or prevent this risk as the product is intended to track the indexes' performance at any given time, even if it does poorly. 

Derivative Risk

Some ETFs employ advanced strategies that use derivatives like options, futures and swaps. These financial instruments are highly complex and can behave in unpredictable ways, especially during periods of high market volatility. Examples include the 2018 "Volmageddon" incident mentioned earlier with short VIX ETFs and what happened to oil futures ETFs when oil prices briefly went negative during COVID-19 crash.

Compare ETF Brokers

Investors looking to research and choose the best ETFs can use Benzinga to compare the available options. Here is a list of brokers that support ETF trading and offer research tools to help investors select the right ETF. 

Investing in ETFs as Your Investment Vehicle

ETF investing can offer a variety of benefits and drawbacks. They provide an efficient way to access a wide selection of securities, with lower fees than mutual funds and the ability to trade intraday. ETFs are easily accessible for both large and small investors making them an attractive option for portfolio diversification.

However, there are potential drawbacks such as tracking errors, liquidity risk, and tax implications. While ETFs can provide a great way to access a variety of asset classes, investors should always consider potential drawbacks before investing and make sure they understand the risks associated with ETFs before making any investments.

Frequently Asked Questions

Q

Are ETFs profitable?

A

Whether or not ETFs are profitable ultimately depends on the underlying assets. An ETF that tracks a broad market index like the S&P 500 is expected to be profitable over the long-term as the underlying companies grow. On the other hand, an inverse ETF that shorts the S&P 500 is unlikely to be profitable over the long term. Over the short term, ETFs could be potentially profitable if the right market conditions that benefit their assets ensue. For example, commodities ETFs can benefit from inflation, while bond ETFs benefit from falling interest rates. Over the long term, profitable ETFs are generally those that hold assets that produce cashflows, such as stocks, REITs or bonds.

Q

Which ETFs are best for investors?

A

The best ETFs for an investor will depend on their investment objectives, risk tolerance and time horizon. For example, a long-term passive investor trying to match the market’s average return may find low-cost index ETFs to be the best option. A retiree seeking above-average income may find a high-yield dividend ETF to be the best option. A risk-averse investor worried about a market crash might find an actively managed hedged ETF to be the best option. 

About Tony Dong

Tony Dong, MSc, CETF®, is a seasoned investment writer and financial analyst with a wealth of expertise in ETF and mutual fund analysis. With a background in risk management, Tony graduated from Columbia University in 2023, showcasing his commitment to continuous learning and professional development. His insightful contributions have been featured in reputable publications such as U.S. News & World Report, USA Today, Benzinga, The Motley Fool, and TheStreet. Tony’s dedication to providing valuable insights into the world of investing has earned him recognition as a trusted source in the finance industry. Through his writing, he aims to empower investors with the knowledge and tools needed to make informed financial decisions.