Pros and Cons of ETFs
PROS
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.
CONS
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.
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.
http://www.etfmarketpro.com/Pros-and-Cons-of-ETFs.html
Pros And Cons Of U.S. Exchange Traded Funds
by Marc Davis on December 16, 2011
Exchange Traded Funds (ETFs) combine features of an index fund and a stock traded on a major exchange. Many are inexpensive, with low management fees, and are tax efficient. An ETF is basically a number of stocks packaged to sell as a single equity. Unlike a mutual fund, however, an ETF can be sold at any time through the trading day, just like a stock. ETFs were initially created to provide a trading vehicle which reflected the price of different indexes. The SPDR, known as the "Spider," for example, tracks stocks in the S&P 500, an index of the 500 largest U.S. companies.
Today, there are literally hundreds of ETFs traded regularly on major exchanges, and represent not only stock indexes, but a variety of other industries and business sectors. There are both positive and negative aspects of ETFs, a smart investor should consider both elements before investing.
PROS
Liquidity
The following applies to both domestic and foreign ETFs traded on U.S. markets. Liquidity is a positive aspect of ETFs, meaning an investor can sell his or her holdings with little difficulty and easily retrieve money from the sale.
Volatility
Volatility is reduced in an EFT because it embodies a number of stocks in a specific market sector rather than just one. A single stock may be more likely to decline substantially due to some internal management problem, or because of the cost of servicing debt has risen, eroding margins and the bottom line, or from some other misstep or misfortune. Although stocks of an entire sector may suffer a simultaneous price decline, often competitors within the sector may prosper as the bottom line of their business rivals shrink or go red.
Market Orders May be Used
ETFs may be sold through market orders, meaning, stop-loss orders, market or limit orders. These permit investors to trade ETFs as if they were stocks, and provide risk management opportunities and better chances of profitability when day trading. ETFs may also be shorted, meaning they can be sold without ownership at the time of sale and bought back later for delivery to the buyer at a lower price, for a trading profit.
Bond ETFs
Bond ETFs are less volatile and offers a reasonably good means of diversifying holdings into fixed income instruments. These can include U.S. Treasury Bonds, or high-rated corporate bonds, providing stability and safety.
Diversity
There are more than 600 ETFs currently traded on the exchanges. Among them are large cap ETFs, packages of large corporations with both value and growth potential. Some small cap ETFs are broadly diversified across business sectors, giving investors an "index" fund of selected companies. There are also Real Estate Investment Trusts (REITs), which have been packaged into ETFs as well. REITs invest in shopping malls, commercial real estate, hotels, amusement parks and mortgages on commercial property.
Tax Efficiency
Because ETF shares are bought and sold on an exchange, just like stocks, the transactions take place between investors who either own the ETFs â the sellers â or who want to buy the shares â the buyers. So, there is no actual sale of the securities in the ETF package. If there is no such sale, there is no capital gains tax liability incurred. There are other circumstances, however, in which an ETF must sell some shares from its package, thereby resulting in capital gains. Investors are urged to consult with their tax accountants or attorneys to advise on complex tax matters.
CONS
Commissions and Trading Fees
Experts have argued that ETFs trade as short-term speculations. Frequent commissions and other trading costs, therefore, erode investor returns.
Limited Diversification
Most ETFs, say some experts, do not provide sufficient diversification. Other authorities, with opposing views, say that there are widely diversified ETFs, and holding them for the long term can produce profits.
The Unknown Index Factor
ETFs tied to unknown or untested indexes, are a major negative aspect of investing in these instruments, say many investment advisors.
The Bottom Line
ETFs generally offer a low cost, widely diverse, tax efficient method of investing across a single business sector, or in bonds or real estate, or in a stock or bond index, providing even wider diversity. Commissions and management fees are relatively low and ETFs may be included in most tax-deferred retirement accounts. On the negative side of the ledger are ETFs which trade frequently, incurring commissions and fees; limited diversification in some ETFs; and, ETFs tied to unknown and or untested indexes.
http://www.investopedia.com/financial-edge/1211/pros-and-cons-of-u.s.-exchange-traded-funds.aspx
