If you are considering ETFs, you should be aware of the pros and cons of ETF investing.
For the typical investor, ETFs line up very well with the fundamentals of good investing. They are diversified, low cost and tax efficient.
Diversification is almost automatic. By regulation, a domestic ETF must hold at least 13 securities and cannot invest more than 30% of the fund in any one security or more than 65% in the 5 most-heavily weighted securities. For international ETFs, the rule is a minimum of 20 securities and a limit of 25% in one and 60% in the top 5. Most ETFs hold many more securities and have a maximum concentration of 5 to 10% of the fund.
ETFs are very low cost relative to their mutual fund cousins. Depending on which study you cite, ETFs have an average expense ratio of 0.4% of assets and no sales loads. Compare that to an annual expense ratio of 1.4% for mutual funds, many of which also come with sales loads. Although a 1% per year difference may not sound like much, it adds up over time. See our post on the free tool from FINRA that will calculate the cost differences between different funds over time. In our example, we calculated a $50,000 – $65,000 savings over a 20 year period.
ETFs are tax efficient because they operate differently than mutual funds. If you buy a mutual fund, you are trading with the fund manager. Share redemptions causes the manager to sell investments to raise cash and creates a tax liability for the remaining shareholders regardless of how long they have held the fund’s shares. This is a major problem for mutual fund investors who paid nearly $34 billion in taxes in 2007.
ETF managers don’t redeem shares for cash – they simply transfer a basket of securities to the redeeming party in a tax-free transaction. As a result, the remaining beneficial owners of the ETF aren’t handed an unexpected tax liability.
As an individual investor, you will typically buy and sell ETF shares on a secondary market rather than trade directly with the ETF sponsor. A taxable capital gains event will occur only when you sell the ETF (there are exceptions – review the ETF’s prospectus with your tax advisor).
There are several other pros to investing with ETFs. They have opened up investment opportunities previously limited to the realm of hedge fund managers and institutions – for example, you can execute a currency strategy very popular with institutions with the PowerShares DB G10 Currency Harvest Fund(Amex: DBV) – see our earlier post.
ETFs make it very easy to pursue strategies that used to be hard to execute – e.g. buy/write strategies, borrowing shares for shorting purposes and investing in hard assets such as gold or silver.
There are cons associated with ETFs. For example, because ETF investing typically requires paying a commission to a broker, investing small amounts of money on a regular basis can be cost prohibitive. Some brokers are working to fix this – for example, ShareBuilder.com offers investors on an automatic investment plan $4 trades or 20 free trades per month for a $20 subscription fee.
Because ETFs are relatively new, they do not adequately cover all investment options. For example, although the markets for stocks and bonds are roughly the same size, the number of fixed income ETFs is only a fraction of equity ETFS. This will likely correct itself as new ETFs pass through the regulatory approval process and come to market.
Finally, specialized funds such as leveraged and inverse ETFs are very powerful investment tools that can do a lot of damage if not used wisely – best to leave these in the hands of your financial advisor.