ETFs and mutual funds are associated with various advantages. Some of these advantages include the ones listed below:
Diversification
A single ETF has the potential of providing exposure to numerous styles, market segments or equities. The ETF has the ability to track a larger range of stocks compared to a stock. In addition, the ETF can attempt to imitate the returns from a country or even a group of countries. For instance, it is possible to lay focus on China, India, Russia and Brazil in a BRIC ETF. It is also possible for mutual funds to be diversified. However, the ETF is associated with lower fees and also trades in a similar manner to an equity investment.
Reduced fees in comparison to Managed Funds
Usually, ETFs are managed passively and are characterized by lower expense ratios when compared to other funds that are managed. The expense ratio of a mutual fund of a mutual funds tends to be higher as a result of several costs like load fees for sale and distribution, paying a board of directors, service fees like marketing, shareholder accounting expenses at the fund level and a management fee.
Trades in a similar fashion to a stock
The ETF trades like a stock despite the fact that it provides the holder with benefits like diversification.
It is possible to purchase ETF on a margin and sell it short.
ETFs are traded at prices that fluctuate in the course of the day. Mutual funds that are open-ended are normally priced at day’s end and this price has to be at the net asset value.
ETFs enable investors to effectively manage risk by trading option and future in a similar manner to a stock. Owing to the similarity in trade between a stock and ETFs, the approximate daily change of a sector or a commodity can be swiftly looked up using a tracking ETF with the ticker symbol. In addition, many websites that deal with stock trades are designed with better interfaces that are ideal for manipulating charts compared to commodity websites. Stock trade websites also provide mobile device applications that are quite convenient.
Immediate reinvestment of dividends
Companies that are in an open-ended ETF normally have their dividends reinvested with immediate effect. However, index mutual funds might have varied timings. It is important to recognize that dividends of unit investment trust ETFs do not get reinvested automatically and this leads to a drag in dividend.
Limitation on capital gains tax exposure
Mutual funds are less tax-efficient compared to ETFs. This is mainly because a majority of the tax on capital gains is entirely up to the investor and is paid on sale. This is regardless of whether the ETF buys or sells shares while trying to imitate the group of shares it is tracking. The primary reason for this is that capital gains from in-kind transfers that are seen in ETFs fail to conclude in a tax charge thus are expected to be lower than mutual funds.
On the other side of the coin, capital gains are expected to be distributed to shareholders but only if the manager has a profitable sale of securities. The amount of distribution is determined on the basis of the holders’ investment proportion and is taxable like a capital gain. In case the sale is done prior to the date of record by other mutual fund holders, the capital gain is divided up by the remaining holders. This means that they pay taxes regardless of whether the fund overall declined in value or not.
Lower premium or discount in price
The probability of having ETF prices which are lower or even higher than the actual value is low. This is because ETFs trade at a price that is quite close to the underlying securities and this happens throughout a day. This means that arbitrage will adjust the price appropriately in case it is significantly lower or higher compared to the net asset value. This varies from closed-ended index funds whereby ETFs trade on the basis of supply and demand. Market makers capture profits in price discrepancy.
Limitations
Outside of the many benefits as list above in trading ETFs, there are some disadvantages too:
May be larger or limited companies
Investors in certain countries may be limited to large-cap stocks because the market index has a narrow group of stocks. The exclusive inclusion of larger stocks will restrict the available exposure to small-cap and mid-cap companies. This situation could keep potential growth opportunities from the grasp of ETF investors.
Intraday pricing might be unnecessary
Investors who are in it for the long term could have a window period of about ten to fifteen years. This means that they may fail to cash in on the intraday changes in pricing. There are investors that might end up trading more as a result of the hourly changes in pricing. A high swing that proceeds over several hours might induce a trade whose pricing could prevent irrational fears from interfering with an investment objective at the end of the day.
Large bid-ask spread
The probability of finding a low volume index investment increases with the creation of more niche ETFs. The end result can be a high bid/ask spread. Investment in the actual stocks or in a managed fund might fetch a better price. Large institutional investors are known to invest in actual stocks.
Higher costs
Investing in ETFs comes at a higher price compared to investing in a certain stock. The commission that is paid to the broker might not vary but stocks lack management fees. This is a very important point to note before you opt to invest in ETFs.
Dividend yields
There are ETFs that pay dividends but the yields are low when compared to owning a group of stocks or a high-yielding stock. Owning ETFs does not come with many risks but investors that take up such risks might benefit from higher dividend yields.
Returns from Leveraged ETF
Double leveraged or triple leveraged ETFs can result in losses that exceed double the tracked index or even triple. Speculative investments of these types require careful evaluation. In fact, the actual loss could exceed double or even triple, if the ETF is held more than 1 day. This is a very important precaution that should not be ignored if you do not want to incur losses.