The Pros and Cons of ETFs

QUESTION: What are the risks and rewards of ETFs (exchange-traded funds) and why should I consider including them in my portfolio when I can just buy everything in them individually?

ANSWER: Well, you could do that, but you’d have to put in a buy order for every stock in the index fund and then a sell order every time you wanted out, and you’d be responsible for rebalancing.

Like mutual funds, ETFs are an efficient way to own a diversified portfolio of stocks. What’s more interesting is that there are some good reasons to own an ETF as opposed to mutual funds. ETFs originally gained popularity as a low-cost way to buy index funds, such as the S&P 500, but they’re not limited to passive investing. ETFs can be actively managed, just like mutual funds.

At first glance, owning an ETF, a mutual fund or individual stocks seem similar. After all, they all give you exposure to the same investments. But tax developments have created several advantages for ETFs:

Tax efficiency – ETFs can rebalance their portfolios without triggering taxable gains for investors. When a mutual fund rebalances, taxable gains are distributed to the investors, meaning you may owe taxes even if you didn’t sell anything yourself. Consequently, ETF investors can better control when gains are realized, which is a powerful planning tool. Over time, a mutual fund and an ETF with identical strategies likely will perform similarly. The difference is timing and control. It’s important to note that this is tax deferral, not tax avoidance.

Trading and settlement – ETFs trade like stocks, letting you lock in prices instantly. In contrast, mutual funds are priced once daily after the markets close. Normally this is not a big deal but can be problematic during periods of high volatility. A drawback is settlement timing.

Additional Risks – Most ETFs invest in highly liquid, publicly traded securities and generally offer risk levels similar to traditional mutual funds. However, there are some ETFs that use leverage, derivatives, or invest in less-liquid assets. These fringe products can behave unpredictably or even fail under stress.

So why isn’t everything structured as an ETF? Great question. Mutual funds have their own benefits for certain strategies, such as automatic investing and reinvesting.