advantages of etfs over mutual funds include all but which one of the following?
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Advantages and Disadvantages of ETFs
You've probably heard that ETFs are better than mutual funds, but you need to consider all aspects before investing. Learn them here.
Since their introduction in 1993, exchange-traded funds (ETFs) have exploded in popularity with investors looking for an alternative to mutual funds. Both institutions and individuals could see the benefit of these instruments—a basket of assets designed to track an index with low management fees and higher intraday price visibility.
But of course, no investment is perfect, and ETFs have their downsides too, ranging from low dividends to large bid-ask spreads. Identifying the advantages and disadvantages of ETFs can help investors navigate the risks and rewards, and decide whether these securities, now a quarter-century old, make sense for their portfolios.
Key Takeaways
Advantages and Disadvantages of ETFs
Advantages of ETFs
There are numerous advantages to ETFs, especially when compared to their mutual fund cousins.
Diversification
One ETF can give exposure to a group of equities, market segments, or styles. An ETF can track a broader range of stocks, or even attempt to mimic the returns of a country or a group of countries.
Trades Like a Stock
Although the ETF might give the holder the benefits of diversification, it has the trading liquidity of equity. In particular:
Because ETFs trade like a stock, you can quickly look up the approximate daily price change using its ticker symbol and compare it to its indexed sector or commodity. Many stock websites also have better interfaces for manipulating charts than commodity websites, and even provide applications for your mobile devices.
Lower Fees
ETFs, which are passively managed, have much lower expense ratios compared to actively managed funds, which mutual funds tend to be. What drives up a mutual fund's expense ratio? Costs such as a management fee, shareholder accounting expenses at the fund level, service fees like marketing, paying a board of directors, and load fees for sale and distribution.
Immediately Reinvested Dividends
The dividends of the companies in an open-ended ETF are reinvested immediately, whereas the exact timing for reinvestment can vary for index mutual funds. (One exception: Dividends in unit investment trust ETFs are not automatically reinvested, thus creating a dividend drag.)
Limited Capital Gains Tax
ETFs can be more tax-efficient than mutual funds. As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds.
Mutual funds, on the other hand, are required to distribute capital gains to shareholders if the manager sells securities for a profit. This distribution amount is made according to the proportion of the holders' investment and is taxable. If other mutual fund holders sell before the date of record, the remaining holders divide up the capital gain and thus pay taxes even if the fund overall went down in value.
Lower Discount or Premium in Price
There is a lower chance of ETF share prices being higher or lower than their actual value. ETFs trade throughout the day at a price close to the price of the underlying securities, so if the price is significantly higher or lower than the net asset value, arbitrage will bring the price back in line. Unlike closed-end index funds, ETFs trade based on supply and demand, and market makers will capture price discrepancy profits.
Disadvantages of ETFs
While the pros are many, ETFs carry drawbacks too. Among them:
Less Diversification
For some sectors or foreign stocks, investors might be limited to large-cap stocks due to a narrow group of equities in the market index. A lack of exposure to mid- and small-cap companies could leave potential growth opportunities out of the reach of ETF investors.
Intraday Pricing Might Be Overkill
Longer-term investors could have a time horizon of 10 to 15 years, so they may not benefit from the intraday pricing changes. Some investors may trade more due to these lagged swings in hourly prices. A high swing over a couple of hours could induce a trade where pricing at the end of the day could keep irrational fears from distorting an investment objective.
Costs Could Be Higher
Most people compare trading ETFs with trading other funds, but if you compare ETFs to investing in a specific stock, then the costs are higher. The actual commission paid to the broker might be the same, but there is no management fee for a stock. Also, as more niche ETFs are created, they are more likely to follow a low-volume index. This could result in a high bid/ask spread. You might find a better price investing in the actual stocks.
Lower Dividend Yields
There are dividend-paying ETFs, but the yields may not be as high as owning a high-yielding stock or group of stocks. The risks associated with owning ETFs are usually lower, but if an investor can take on the risk, then the dividend yields of stocks can be much higher. While you can pick the stock with the highest dividend yield, ETFs track a broader market, so the overall yield will average out to be lower.
Leveraged ETF Returns Skewed
A leveraged ETF is a fund that uses financial derivatives and debt to amplify the returns of an underlying index. Certain double or triple leveraged ETFs can lose more than double or triple the tracked index. These types of speculative investments need to be carefully evaluated. If the ETF is held for a long time, the actual loss could multiply fast.
For instance, if you own a double leverage natural gas ETF, a 1% change in the price of natural gas should result in a 2% change in the ETF on a daily basis. However, if a leveraged ETF is held for greater than one day, the overall return from the ETF will vary significantly from the overall return on the underlying security.
A double-leveraged ETF does not always mean you will see double the return of the index. And the ease of investing in leveraged ETFs could entice individuals with little experience or understanding of the investment vehicle.
The Bottom Line
ETFs are used by a wide variety of investors to build a portfolio or gain exposure to specific sectors. They are like stocks in the way they trade but can also be compared to more broad investments, or even entire indexes, in their price movements. They have many advantages, especially compared to other managed funds such as mutual funds.
But there are also disadvantages to watch out for before placing an order to purchase an ETF. When it comes to diversification and dividends, the options may be more limited. Vehicles like ETFs that live by an index can also die by an index—with no nimble manager to shield performance from a downward move. Finally, the tax implications associated with ETFs (as with any investment) need to be considered when deciding if they are for you.
Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.
Exchange
Exchange-traded funds (ETFs) combine aspects of mutual funds and conventional stocks. Like a mutual fund, an ETF is a pooled investment fund that offers an investor an interest in a professionally managed, diversified portfolio of investments. But unlike mutual funds, ETF shares trade like stocks on stock exchanges and can be bought or sold throughout the trading day at fluctuating prices.
Exchange-traded funds (ETFs) combine aspects of mutual funds and conventional stocks. Like a mutual fund, an ETF is a pooled investment fund that offers an investor an interest in a professionally managed, diversified portfolio of investments. But unlike mutual funds, ETF shares trade like stocks on stock exchanges and can be bought or sold throughout the trading day at fluctuating prices.
Are All ETFs Alike?
No. ETFs can vary in a number of ways:
ETF Nuts and Bolts
Unlike mutual funds, ETFs do not sell shares to, or redeem shares from, retail investors directly. To make it possible for investors to buy and sell shares on an exchange, ETFs follow a unique format. An ETF enters into contracts with financial institutions (typically large broker-dealers) to act as Authorized Participants (APs). APs purchase and redeem shares directly with the ETF in large blocks of shares called Creation Units. APs typically sell some or all of their ETF shares on an exchange. This enables investors to buy and sell ETF shares like the shares of any publicly-traded company.
Buying and Selling ETFs
Investors purchasing or selling shares in an ETF typically pay a brokerage commission on each transaction. When you purchase or sell ETF shares, you receive the market price on the exchange at the time the order is placed. This price may fluctuate throughout the trading day. A mutual fund, on the other hand, determines its net asset value at the close of each trading day. When you purchase or redeem mutual fund shares, you receive the price based on the net asset value next computed after you submitted your order. The intraday pricing of ETFs tends to provide investors with greater trading flexibility, because you can monitor how the price is doing and do not have to wait until the end of the day to know your purchase or sale price.
As with other investments, you can make money with ETFs if you sell your shares for more than you paid. You also benefit if the securities an ETF holds pay interest or dividends. That income may either be reinvested or paid to shareholders quarterly or annually, depending on the way the ETF is structured. An ETF may also decline in value. Of course, if the value falls and you sell, you may have a loss.
Unlike mutual funds, it is possible to buy ETFs on margin and sell them short. These advanced investment strategies may be useful for some experienced investors—though for other investors, the costs and risks of such strategies might outweigh the potential benefits.
With ETFs, you typically pay a commission on each transaction, like individual stocks. For this reason, ETFs are generally not recommended for incremental investing strategies such as dollar-cost averaging: The sales charges you pay for each purchase or sale could erode your investment return. The same caution applies to mutual funds that charge front-end sales loads.
A number of ETF providers have begun to offer no-commission ETFs. While this can be advantageous to investors who plan to make numerous small trades, the no-commission sales angle shouldn’t be the sole factor in determining which ETF to purchase. You will want to read the fine print with regard to no-fee trades (at least one firm charges you a fee if you buy a no-commission ETF and trade it within 30 days of purchase). And as we describe next, ETFs also have expense ratios to consider—a different type of cost to you that can add up.
ETF Expenses
In addition to any brokerage commission you may pay, ETFs have expense ratios, like mutual funds, calculated as a percentage of the assets you have invested. ETFs do not have loads or 12b-1 fees (fees that are taken out of a mutual fund's assets annually to cover the costs of marketing and distributing the fund to investors).
In general, actively managed ETFs cost more than passively managed index ETFs. Before purchasing ETF shares, carefully read all of an ETF’s available information, including its prospectus. All ETFs will deliver a prospectus upon request.
ETFs and Taxes
You can own ETFs in taxable, tax-deferred or tax-free accounts. In taxable accounts, any capital gains you realize from selling fund shares are taxed in the year you realize them, though the rate that applies may be your long-term capital gains rate.
In contrast, in a tax-deferred account, any gains become part of the total assets in the account and are taxed as ordinary income when you withdraw them at some point in the future. In a tax-free account, any gains or income will not be taxed if you follow the rules for withdrawals.
While ETFs held in a taxable account will generally result in less tax liabilities than if you held a similarly invested mutual fund in the same account, there can be exceptions. Leveraged in inverse ETFs can create tax liabilities. So can certain exotic ETFs—for instance certain emerging market funds and funds that invest in precious metals, which are considered “collectables” by the IRS, taxed as ordinary income for short-term gains and 28 percent for long-term gains.
For more information about the tax treatment of a particular ETF, make sure to read the prospectus
More Information
The following resources provide additional information about ETFs:
ETF vs mutual fund: Compare similarities, differences
Compare ETF vs. mutual fund minimums, pricing, risk, management, and costs, then weigh the pros and cons.
Cut your costs with ETFs
Maybe you're thinking about handcrafting your portfolio. Before you do, make sure you understand the costs. (All examples below are hypothetical.)
Trading individual stocks
Imagine you want 25 different stocks in your portfolio, each of which is selling for $50 a share, and you're charged a $5 commission for each trade.
$1,250 purchase price (25 stocks multiplied by $50 per share)
+ $125 in commissions (25 stocks multiplied by $5 per stock)
= $1,375 total cost
Trading ETFs
An ETF can help you obtain the same level of diversification but at a much lower cost.
For example, imagine you buy 1 ETF that holds all 25 stocks and costs $50 a share, and you enjoy Vanguard's commission-free trading.
$50 purchase price (1 ETF multiplied by $50 per share)
+ $0 in commissions (for Vanguard ETFs® held in a Vanguard Brokerage Account)
= $50 total cost
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