Pros and Cons of ETFs

Investing in exchange-traded funds (ETFs) is often a low-cost way to diversify your portfolio. However, that doesn't mean they are without drawbacks. Here are some of the pros and cons of ETFs:

Definition According to Nasdaq, ETFs track, but do not try to outperform, indexes like the Standard & Poor's 500, Nasdaq-100 Index and Dow Jones Industrial Average. They trade like stocks but resemble mutual funds in that buying shares of one means some degree of ownership in a basket of stocks.

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Most ETFs are managed passively, meaning the fund manager makes minor, periodic adjustments instead of continually trading assets. Investors looking to get involved with ETF have a number of options; assets classes include foreign stocks, equities, fixed income, commodities and real estate.

ProsDavid Twibell, the president of Englewood, Colo.-based Custom Portfolio Group LLC, says that ETFs have low annual expenses, especially in relation to mutual fund charges. Typical ETF administrative costs are less than two-tenths of one percent (or 20 basis points) per year, compared to the more than 1 percent annual costs of some mutual funds, according to Nasdaq.

ETFs can also be more tax-efficient, says Twibell. They only generate taxable capital gains when sold, unlike actively-traded mutual funds that annually pass through taxable capital gains.

"This can make a huge difference in your overall net investment returns," he says, "particularly if you intend to hold a fund for an extended period of time."

Twibell explains that ETFs can be bought and sold through a broker without restriction during the trading day. This gives investors more flexibility, especially when compared to mutual funds, which only trade at the end of the day.

This makes it easier for ETF investors to use risk-management strategies like stop-loss orders, which call for the buying or selling of securities when they reach a particular price, and limit orders, which set the maximum and minimum purchasing and selling prices, he says.

Cons Bill Hammer, a certified financial planner and vice president of wealth management at Melville, N.Y.-based Vanderbilt Partners, says that the bid-ask spreads (the difference between the bidding and asking price) on ETFs can be large with smaller assets under management. The smaller the spread, the lower the cost. ETFs are not as, say, liquid as small-cap stocks, he says, so you may not get the ETF at Net Asset Value (NAV). This means you could overpay for the portfolio, or selling it for less than it is worth, explains the Wall Street Journal. Therefore, it might be to your advantage to invest in the actual stocks instead of an ETF.

Kevin Worthley, a certified financial planner at the Warwick, R.I.-based Retirement Planning Company of New England, says that emotional reactions to events in one major company within the sector can amplify the short-term trading of ETFs. A price drop in a company like Apple can trigger the sale of ETFs that include its stock, potentially resulting in increased volatility.

Worthley points out that purchasing shares of an ETF means you get "the good, the bad and the ugly" of the companies within the fund.

"It's like buying green beans at the market," he says. "Grab a handful of beans and you'll get some long, fat beans, but you'll also get some gnarly, withered, inedible ones."