Exchange-traded funds (ETFs) are investment funds that are traded on stock exchanges, similar to shares. They hold assets such as shares, commodities or bonds and usually track an index, although there are also actively managed ETFs. ETFs have grown in popularity in recent years due to their simplicity, tax efficiency and relative cost effectiveness.
Possibilities:
- Diversification: ETFs offer instant diversification as they hold a collection of different investments (e.g. equities, bonds, commodities) in a single fund.
- Access to different markets: Investors can use ETFs to gain access to a wide range of domestic markets, foreign markets, sectors, commodities or asset classes that would otherwise be difficult to access.
- Liquidity: ETFs are traded on exchanges and therefore offer high liquidity, allowing investors to open or close positions quickly.
- Cost efficiency: Compared to traditional mutual funds, ETFs generally have lower fee structures because they are passively managed (although actively managed ETFs do exist).
Advantages:
- Lower costs: ETFs tend to have lower annual fees than mutual funds, and transaction costs are generally similar to those of trading stocks.
- Flexibility: Because they are traded on exchanges, investors can buy and sell ETFs at any time during regular trading hours, unlike mutual funds, which are only traded at the end of the trading day.
- Transparency: ETFs are required to disclose their exact holdings on a daily basis, giving investors a clear understanding of what their money is invested in.
- Tax efficiency: ETFs are generally more tax efficient than traditional mutual funds because of the way they are structured and trades are executed.
Disadvantages:
- Trading costs: Although ongoing costs can be low, investors typically have to pay brokerage fees each time they buy or sell ETF shares, which can negatively impact smaller or more frequent trades.
- Market risk: As with any investment in the market, ETFs are exposed to market fluctuations, which can lead to losses.
- Tracking error: This is the risk that the ETF does not track its benchmark exactly. Although this can also be a problem with traditional funds, it is more often highlighted with ETFs because of their association with passive management.
- Complexity of some products: While many ETFs track traditional asset classes or indices, others may invest in derivatives or employ complex strategies that may not be suitable for average investors (e.g., leveraged or inverse ETFs).
ETFs offer an effective way for investors to hold diversified investments in their portfolio, but as with all investment decisions, it is important to do research and possibly consult a financial advisor to ensure that the specific ETFs one is considering match one’s investment goals and risk tolerance levels.
