They’re flexible and low-cost, and their underlying portfolios are protected from the impact of investor trading, which makes them more tax-efficient than mutual funds. They are exchange traded funds, essentially a basket of securities traded on the American Stock Exchange that are structured as open-ended mutual funds to offer low-cost exposure to the stock market.
The following are some of the advantages of ETFs:
- Unlike open-end mutual funds that can only be redeemed at the end of the day, ETFs are priced throughout the day and can be bought or sold just like a stock.
- You can choose a fund that either represents a broad-based market index, a specific industry sector, or an international sector.
- ETFs can be bought on margin.
- ETFs can be sold short.
- There are no sales loads with ETFs (but brokerage commissions do apply).
- ETFs provide a tax advantage not available with mutual funds: They transfer securities out to redeeming shareholders instead of selling the securities, thus minimizing taxable capital gains.
Nevertheless, investors are advised to look carefully before they invest in ETFs for several reasons. ETFs’ cost advantage is not always as large as it might seem and their trading costs can quickly add up. And although ETFs are more flexible than mutual funds in many respects, investors must buy or redeem shares directly from the fund company in 50,000-share blocks. Even then the funds require in-kind transactions, which means investors are paid in underlying stocks, not cash, when they redeem their shares.
But by far the greatest disadvantage of ETFs is the commissions that must be paid to buy and sell them (just as in stock transactions). If you plan to invest regular sums of money, you’ll end up paying far more with an ETF than with many mutual funds. If you want to trade frequently you would be much better off from a cost perspective with a regular mutual fund than with an ETF.
Another consideration and possible drawback of ETFs is that because they’re traded on the open exchange they don’t necessarily track the net asset value of their holdings. An ETF, for example, might trade 2 percent below the value of the shares of the companies contained in it. In theory when such an imbalance occurs a third party might step in and buy or sell shares in large blocks (called “creation units”) and redeem them for the underlying shares. Premiums and discounts could arise, especially for thinly traded funds.