Investing in Exchange Traded Funds (ETFs) has become increasingly popular in recent years. ETFs are unique in that they offer a low-cost and convenient way to access a wide range of markets and asset classes. Discover the pros and cons of investing with ETFs in our article.

Advantages of investing with ETFs

These days, many people prefer ETFs to mutual funds because of the many advantages they offer. We have compiled a list of the pros and cons of investing in ETFs to help you make better decisions about what to choose when building your portfolio. It may also help you avoid making costly mistakes by choosing illiquid or risky ETFs and help you analyse them better.  Some of the key benefits of investing in ETFs include:

  • Diversification

ETFs provide instant diversification by allowing you to gain exposure to a basket of stocks or other securities within a particular sector, index or asset class. It helps you to spread risk across a number of holdings by buying a single security, the ETF, similar to buying a mutual fund.

  • Low costs

ETFs generally have lower expense ratios than actively managed mutual funds because most ETFs are passively managed and track an underlying index or market sector. This is a key cost advantage that can lead to better long-term returns for investors.

  • Intraday trading 

Unlike investment funds, which only trade at the end of the day, ETFs can be bought and sold throughout the trading day, just like shares. This allows you to make timely trading decisions and take advantage of market timing, such as when a sudden dip occurs. You can also use various trading strategies such as limit orders and stop-limit orders throughout the day.

  • Tax efficiency

Depending on where you live, ETFs may be structured in a way that makes them more tax-efficient than mutual funds or investment trusts: in some countries, ETFs are only subject to capital gains tax when you sell your shares, whereas mutual funds or investment trusts may incur capital gains tax each year due to the fund's internal trading activities or dividend payouts.

  • Access to a range of traditional and alternative asset classes

According to Blackrock, there are over 8,000 ETFs listed globally. They cover a wide range of asset classes, including equities, bonds, commodities, currencies and property, making it easy to diversify your portfolio by buying just a few securities.

  • Liquidity

ETFs are traded on exchanges, making them highly liquid investments. This means that investors can easily buy and sell shares in an ETF throughout the trading day, allowing them to efficiently manage and rebalance their portfolios and react to the latest market news.

  • Create simple and effective investment strategies

ETFs can be used to implement various investment strategies, such as the 60-40 portfolio, which invests in a combination of at least one equity ETF and at least one bond ETD. This strategy provides a low-cost, diversified and easy-to-manage investment solution for long-term investors.

Disadvantages of ETFs

While there are many advantages to using ETFs to construct a passive portfolio or to actively invest in stocks and trend sectors, there are also a number of disadvantages, most notably the hidden risks of leveraged ETFs and the illiquidity and high costs associated with niche ETFs.

  • Risk of leveraged  and short ETFs

Leveraged ETFs have become a very popular investment tool to enhance returns and there are many different versions of these ETFs, including short ETFs and ETFs offering up to 10X leverage on a particular security or index.

While the risk of high leverage is well understood, even 2X leverage can lead to a near total loss of capital over time.

A key problem with leveraged ETFs is that the leverage is usually applied on a daily return basis, so if the stock rises 10% on a particular day and the ETF is leveraged 2X, the return would be +20%. However, over time, because of the cumulative nature of the returns, these ETFs tend to lose money. Imagine that the next day the stock drops by 10%, it is back to where it was 2 days ago and the return on investing directly in the stock is 0. However, the ETF drops by 20%, meaning it has lost a total of 4% since the first trading day. To illustrate: 100 * 1.2 = 120. 120 * 0.8 = 96. Because of this effect, if the market moves sideways or falls, the expected return on a leveraged ETF is negative over a long time horizon.

As for unleveraged (1X) short ETFs, there is also the risk of a complete loss of capital: in 2018, some short ETFs on the Volatility Index VIX fell by more than 85% in a single day and had to be delisted.  In 2018, certain short ETFs on the VIX fell by more than 85% in a single day and had to be delisted as the VIX nearly doubled due to a sudden market crash.

You can learn more about the risks that arise from thematic ETF opportunities here. 

  • Trading fees and Bid-Ask Spread

ETFs trade like stocks throughout the day. As a result, it is important to check your brokerage fees for trading ETFs and check the bid-ask spreads before buying or selling an ETF, as some ETFs can be illiquid with large bid-ask spreads which puts you at a disadvantage when investing.

  • Operating expenses 

ETFs charge an annual fee, called the expense ratio, which covers management fees, administrative costs and other operating expenses. Although ETFs generally have lower expense ratios than mutual funds, niche ETFs in particular can have fees of 1% or more, which can significantly affect your overall returns. So before you invest in an ETF, make sure you read the terms and conditions or the KIID document if you live in Europe.

  • Low trading volume

Some ETFs, particularly those that track niche or less popular market segments, may have low trading volumes. This can lead to wider bid-ask spreads and increased price volatility, making it harder for you to buy or sell shares at the right price.

  • Tracking errors

ETFs aim to replicate the performance of an underlying index or asset. However, discrepancies between the ETF's performance and its benchmark can occur due to factors such as management fees, trading costs, and portfolio rebalancing. These tracking errors can result in the ETF underperforming its benchmark.

  • Lack of liquidity

Although ETFs are generally more liquid than mutual funds, some funds may experience reduced liquidity in certain market conditions or due to low trading volumes. This can make it difficult for investors to buy or sell shares at their desired price and may result in increased price volatility.

In summary, ETFs offer many advantages over mutual funds and other actively managed vehicles such as unit trusts, but it is important to review the documentation for each ETF and check its expense ratio, risk characteristics, liquidity and bid-ask spreads, and any tracking error before adding it to a investment list. As proven in this article, there is a lot that goes into choosing the right ETFs for a portfolio, but taking in as much information as possible will stand you in good stead for success.