Advantages and disadvantages of ETFS
Because of the passive management of ETFs, fees are low, and the
turnover of securities is low, which (similar to index mutual funds)
results in low capital gains taxes. See Table 16–3 for the advantages
and disadvantages of investing in ETFs.
SHOULD AN INVESTOR INVEST IN
INDIVIDUAL SECURITIES OR USE
ETFS OR FUNDS?
The diversification achieved by mutual funds, closed-end funds,
and ETFs minimizes the effect of any unexpected losses from individual
stocks and bonds in a portfolio. Also, professional managers
of mutual and closed-end funds may have quicker access to information
about the different issues and may react sooner in buying
or selling the securities in question. ETFs are similar to index funds
and are not actively managed.
For investors willing to manage their own portfolios, a strong
argument exists for buying individual securities over mutual funds.
The rates of return on individual stocks have the potential to be
greater than those earned from mutual funds. This statement is true
even for no-load funds because in addition to sales commissions,
other fees, such as 12(b)–1 and operating fees, reduce the returns of
mutual funds. By investing in individual securities, you avoid these
fees. ETFs generally have lower management fees than mutual
funds. However, commissions are charged to buy and sell individual
stocks, ETFs, and closed-end funds.
Table 16-3
The Advantages and Disadvantages of Investing in ETFs
ETFs bear similarities to open-end mutual funds, index funds, and closed-end
funds. Knowing the advantages and disadvantages of ETFs will help you to
determine which type of investment is more suitable to your needs.
* ETFs offer diversification (similar to mutual funds), but they trade as stocks.
Even though the stock prices of ETFs that track the different indexes fluctuate
when markets are volatile, the effect of the fluctuations on each of the indexes
may be more muted than in a portfolio of individual stocks.
* ETFs charge low fees and generally are tax efficient in the management of
these securities, making them similar to index funds. (Some newly introduced
ETFs to the market have increased their fees, which suggests that investors
should check the fees charged before investing).
* ETFs are bought and sold through brokers, just like any other stocks on the
market at real-time price quotes during the day. Mutual funds can only be traded
once a day at their closing prices.
* Investors do not need large amounts of money to be able to buy ETFs, which
gives them broad exposure to a market index, a sector of the market, or a
foreign country.
* The disadvantage of ETFs is that investors incur commissions to buy and sell
shares, whereas no-load mutual funds charge no transaction fees to buy or sell
shares. These transaction costs to buy ETFs make it uneconomical for investors
who typically invest small amounts of money on a frequent basis.
* Sector ETFs may be too concentrated in their sectors to share in the gains of
their sectors. In 2006, the telecommunications sector had large returns that
were not shared by some of the telecommunications sector ETFs (Salisbury,
2006, p. C11).
If you have a small amount of money to invest, mutual funds
and ETFs are better alternatives. A $2,000 investment in a stock
fund buys a fraction of a diversified portfolio of stocks, whereas
for individual securities, this amount might allow for buying only
the shares of one equity company. Investing in mutual funds is
good strategy if you do not have enough money to diversify your
investments and do not have the time, expertise, or inclination to
select and manage individual securities. In addition, a number of
funds offer you the opportunity to invest in the types of securities
that would be difficult to buy individually. ETF investors are not
hampered by the minimum investment amounts set by mutual
funds. Investors can buy a single share of stock in an ETF.
Table 16-4
Characteristics of Individual Securities versus Mutual Funds,
Closed-End Funds, and ETFs
|
Individual
Securities |
Mutual
Funds |
Closed-End
Funds |
ETFs |
| Diversification |
Achieved only if
a large number
of securities is
purchased |
Achieved with a small
investment. |
Achieved with a
small investment. |
Achieved with a
small investment. |
| Ease of buying
and selling |
Easy to buy and
sell stocks at
real-time prices
during the trading
day. More
difficult to buy
bonds. |
Easy to buy and sell
shares. Trades
occur only at the
closing price at the
end of the day. |
Easy to buy and
sell liquid closedend
funds. |
Easy to buy and
sell ETFs at
real-time prices
during the day. |
| Professional
management |
No |
Yes |
Yes |
Replicates a
market index. |
| Expenses and
costs to buy
and sell |
Brokerage fees
to buy and
sell. |
Low to high expenses,
depending on
fund. |
Low to high
expenses,
depending on
fund. |
Brokerage fees to
buy and sell and
low fees. |
| Tax planning |
Easier to predict
income and plan
capital gains
and losses. |
Can upset careful tax
planning owing to
unpredictable
distributions of
income and capital
gains. |
Can upset careful
tax planning
owing to unpredictable
distributions
of income
and capital gains. |
More tax efficient
than mutual
funds. |
Table 16–4 compares some characteristics of investing in
individual securities versus mutual funds, closed-end funds, and
ETFs.
|
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