What are ETFs? — Pros and Cons

April 11th at 4:00pm by Tom Lydon

Exchange traded funds have become a popular alternative to investing with mutual funds. These investment tools have plenty of attractive traits, however, they also come with some points of caution.

Exchange traded funds originally launched in the early 1990s, and the first ETF was the SPDR S&P 500 (NYSEArca: SPY) which was designed to track the S&P 500. In 2008, ETFs were designed to do other investing techniques than simply tracking a broad index. Today, there are over one thousand ETFs to choose from, totaling over $1 trillion in assets. [Why More Money Managers are Using ETFs]

Dave Meyer reported for NPR and interviewed financial commentator Greg Heberlein about the pros and cons of ETF investing. Here are a few of the pros:

  • Tax Advantages: ETFs have tax advantages over mutual funds. For instance, many ETF gains are reinvested, so the brokerage account can grow and compound while avoiding taxes.
  • Diversification: This is a key concept of portfolio construction. As John Bogle likes to say, a stock or an investment manager can outperform the general market for a relatively short period of time, but almost never over long periods, reports NPR. ETFs can diversify a portfolio because they are baskets of stocks that track a sector or asset class. And since they are easy to buy and sell, navigating the market is as simple as selling a single stock.
  • Lower Fees: Since ETFs are not actively managed, they have much lower operating costs than mutual funds. Fees can add up when the ETF is traded too frequently, though. [What are ETFs? Portfolio Building Blocks]

A few of the cons:

  • Narrowly focused ETFs: Some of the niche ETFs are so specialized and track an index of a not-so-popular slice of the market that it just poses too much risk. The same upside of an ETF, that they track special sectors, is also a dangerous feature. The problem with niche sectors is that they don’t always attract enough assets to give adequate liquidity.
  • Short-Term Trades: While traders and investors both like the nimble feature of an ETF, this can also work against them. Too many trades can rake up brokerage fees, and this can negate low costs. Broad-based ETFs that are held for some time tend to be very cost-effective.
  • Derivatives: Some ETFs targeting overseas stocks and indexes use speculative derivative contracts. The derivative market has exploded to more than $700┬átrillion. Some believe that if the market moves suddenly, certain derivatives could unravel, accentuating the loss. Today, derivatives are known to be dangerous to the average investor, and they are not legal to use in new ETFs. [ETFs: Don't Judge a Book by its Cover]

Tisha Guerrero contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

Tickers

SPY