ETFs (Exchange-Traded Funds) are a variety of funds that track stock market indices. But unlike traditional mutual funds, ETFs trade like stocks and prices are determined by market forces of demand and supply.
This is one of the features that differentiate them from traditional mutual funds. While they both track various stock indices, in mutual funds the value of the underlying asset is determined by the weighted value of all the assets in the tracked index subtract the total liabilities divided by the outstanding shares of the index members. This value is updated every 15 seconds.
Another distinction between ETFs and Mutual funds is that when it comes to trading fees. ETFs have low fees, this is different from mutual funds, whose fees are mostly a higher fixed as a percentage of invested capital. This ETF guide explains one of the reasons why ETFs tend to attract low management expense ratios compared to traditional mutual funds is because the track indexes and follow a passive approach to investing rather than have people actively picking stocks.
The Pros and Cons of Investing in ETFs
- ETFs attract low trading fees than Mutual Funds and this makes them attractive to retail traders. The fees/commissions are normally under 0.5%.
- ETFs are more tax-efficient than traditional index funds. This is primarily because capital gains tax is not charged to traders unless they sell their holdings in a particular ETF.
- ETFs provide investors with an exemplary opportunity to diversify their investments. This can be done by choosing to invest in different ETFs that track distinct classes of assets. For instance, a trader can choose to invest in an ETF that tracks emerging markets stocks, small-cap stocks, or a specific industry like semiconductor stocks, etc.
- Unlike traditional mutual funds, ETFs are more transparent. Investors know exactly the assets they are investing in by looking at the member companies of index funds tracked by the ETF. Whenever a company is removed from or added to the index fund, traders can access that information easily allowing them to reassess the risk factor of the updated ETF.
- ETFs allow traders to buy and sell multiple times during the day, just like stocks. This is a key benefit compared to mutual funds where traders can only buy/sell once a day.
- One of the biggest drawbacks of ETFs is that while the fees charged a competitively low, those commissions can add up quickly especially for investors that intend to build their portfolios slowly. Investing small amounts on a daily basis can be detrimental in the long run if you are being charged to make trades regularly.
- ETFs often attract low trading volumes. This leads to a widening of the bid-ask spread, which in turn can be too big to be cost-effective.
- In the U.S. traders can access multiple ETF products, however, in other global markets, ETFs products are limited to mega-cap assets like share indices. This makes international diversification complicated for retail traders. For domestic investors, its easier to invest in different ETFs to diversify.
- While ETFs provide traders with an opportunity to trade on a daily basis, sometimes they lack enough activity to attract day traders and this may deter most traders from engaging in ETF investing.
In summary, ETFs provide retail investors with an opportunity to invest in well-diversified blue-chip index funds without having to commit sizeable amounts of capital. In addition, traders can also participate more in the market because of intraday trading, which is not available to mutual fund investors.