Learn all about Exchange Traded Funds (ETFs). How reliable and viable are ETFs? What are the advantages, disadvantages, and risks inherent in ETFs?
What is a ETF
A ETF, or Exchange Traded Fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have lower fees than mutual fund shares, making them an attractive alternative for individual investors. Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated once at the end of every day like a mutual fund does.
1. Trading Flexibility
Traditional open-ended mutual fund shares are traded only once per day after the markets close. Investors must wait until the end of the day when the fund net asset value (NAV) is announced before knowing what price they paid or sold that day. ETFs are bought and sold during the day when the markets are open. The pricing of ETF shares is fluid during normal exchange hours.
2. Portfolio Diversification
Investors may wish to quickly gain portfolio exposure to specific sectors, styles, industries, or countries but do not have expertise in those areas. Given the wide variety of sector, style, industry, and country categories available, ETF shares may be able to provide an investor easy exposure to a specific desired market segment or country. Leveraged on inverse ETFs are also available.
3. Lower Costs
ETF operation costs are low as client service–related expenses are being passed on to the brokerage firms that hold the exchange-traded securities in customer accounts. Fund administrative costs can go down for ETFs as the manager does not have to answer questions from thousands of individual investors. ETFs also have lower expenses in the area of monthly statements, notifications, and transfers.
1. Limited Companies/Opportunities
In some countries, investors might be limited to large-cap or certain stocks due to a narrow group of stocks in the market index. This could leave potential growth opportunities out of the reach of ETF investors.
2. Lower Trade Volumes
Low volume ETFs lead to larger bid and ask spread for the ETF shares. Higher ownership of individual stocks by ETFs widens the bid-ask spreads in the share, making them more expensive to trade and less attractive. This effect of lower trade volume is reduced when there are ready market makers.
3. Negative Impact to Capital Market
The emergence of robo advisor and ETFs are an important development in financial markets, which have brought many well-documented benefits to investors. However, the emergence of this trend has led to several unintended long run consequences for pricing efficiency. When fewer trades occur, liquidity in single stocks deteriorate, raising transaction costs and further discourages individual investors. The reduced interest in individual equities also results in lesser analyst coverage.