Chapter 4: Pros and Cons of Investing in Exchange Traded Funds (ETFs)

Content Producer · 30 September 2020
When it comes to choosing which investment option is right for you, it can be hard to know where to start and investments like ETFs can have a range of pros and cons.

As you would have read in Chapter One, knowing your investment goals is an important first step to investing. Whether you’re still debating if you should pursue property or shares, or are ready to learn more about the different types of share investment options available to you, choosing the right investment portfolio for you can be more complicated than it may first appear.

But it doesn’t have to be!

You see, there are a number of share investment options available designed to help beginners break into the share market or give seasoned investors access to more diversification in their portfolio.

One of those options is Exchange Traded Funds (or ETFs).

Like we discussed in Chapter Two, ETFs are a type of index fund that involves a collection of stocks that often track an underlying index, although they can invest in a wide range of industry sectors or utilise various strategies. Though they contain a number of stocks, an ETF is actually a singular entity that can be bought and sold accordingly. ETFs are also in many ways similar to mutual funds and feature a number of pros, such as the fact that they are traded throughout the day just like ordinary stock, as well as a number of cons.

An investment portfolio that is diversified across a number of investment options is a cornerstone of the journey to financial success and security. ETFs can provide a good beginning to the diversification of your investment portfolio, so in this article, we’re going to provide expert insight into the pros and cons of ETFs for investors like you.

The Pros of Investing in ETFs

1. They can be traded like an individual stock

An ETF gives its holders all the benefits of diversification while offering the same liquidity as individual shares. This means that ETFs can be sold and bought throughout the day depending on different fluctuations in the market. In fact, the price that ETFs trade at is updated throughout the day. This is in contrast to an open-ended mutual fund, which is priced at the end of the day at the net asset value.

2. They allow for effective portfolio diversification

As ETFs track an already-established index of stocks, they can offer diversification across a number of market segments or even countries. An ETF can also allow you to spread your portfolio across multiple industries, which can work to help you weather any fluctuations that may occur in the share market.

ETFs can even attempt to mimic the investment returns of a country or a group of countries, due to the way that they spread their index of stocks across sectors. We mentioned it before, but as investment experts we believe that diversification is one of the keys to securing a brighter financial future. By diversifying your investment portfolio, you’re acting to mitigate any fluctuations that may occur in the share market as well as protecting yourself in the case one or more industries suffers a drop in share value.

3. They offer lower fees than other investment options

Since ETFs are passively managed, they typically have much lower fees as a result of their being less expenses required to run them. Actively-managed funds, which mutual funds tend to be, have to take into account aspects like management fees, shareholder accounting expenses, any marketing fees required, and load fees for sale and distribution when setting the fees they charge you. The calculations of these expenses in relation to returns is known as the expense ratio (ER), which measures how much of a fund’s assets are used for administrative and other operating expenses. Expense ratios are calculated by dividing a fund’s operating expenses by the average dollar value of its assets under management (or AUM).

As a passively-managed fund, ETFs don’t have to take into account the expenses of their actively-managed counterparts and are able to pass this lower operating cost onto you in the form of a lower expense ratio and lower fees. This makes ETFs a particularly viable investment option for beginner investors who may be wanting to break into the share market but who don’t want to be paying a portion of their potential returns in fees in exchange.

4. They can be more tax-effective than other share options

ETFs are also an excellent investment option for those seeking to lower their tax obligations while still growing their wealth through an investment portfolio.  As passively-managed portfolios, ETFs and index funds tend to make fewer capital gains than actively managed mutual funds. This means that you as an investor will face lower capital gains tax by utilising ETFs as part of your investment portfolio as you would if you utilised mutual funds instead.

The Cons of Investing in ETFs

1. They may return lower dividend yields

While there are indeed dividend-paying ETFs, the yields they return may not be as high-yielding as individually-held stocks or groups of stocks. This is due to the fact that ETFs track a broader market than individual stocks, meaning that their overall yield on average may be lower when compared to buying those individual stocks outright.

The risks associated with owning ETFs are usually lower than other types of funds as well, due to their diverse nature, which can result in a lesser but more stable return. If you as an investor have a higher risk tolerance, than a different type of stock may be more suitable to your particular financial situation. If you’re unsure, talk to a financial advisor or other trusted financial professional to learn more for unique financial circumstances.

2. They can have higher trading costs than other share options

When discussing ETFs, most people will compare trading them to other types of funds, in which case the overall trading costs will usually be lower. However, when comparing investing in ETFs to investing in the same shares but individually, the trading costs may be lower when performing the latter.

Depending on the make-up of the ETF you may be considering investing in, you may end up paying a small management fee on top of the commission paid to the broker of the stocks tracked by your ETF. This can result in higher trading costs. When investing in individual stocks, you only have to worry about the brokerage fee, meaning lower trading costs for you.

3. Their liquidity can encourage trade at the wrong time

Due to the fact that ETFs can be bought and sold throughout the day, in combination with their diverse nature, it can be said that this may encourage investors to engage in poor investor behaviour. Buying and selling shares in whichever form you choose to pursue on a short-term basis can lead to you losing out on long-term growth that is essential to achieving financial success and security. This is especially true for those intending on engaging in this day trading with the intent of beating the market average.

Still not sure ETFs are the right option for you?

Just like many aspects of your financial world, if you’re unsure about whether ETFs are the right investment option for you, we’d recommend reaching out to a financial advisor for support.

Having a dedicated financial advisor by your side ensures that you’ll have expert investment advice tailored to your particular financial situation and goals only a phone call or email away.

And when it comes to achieving financial success and security, we know that you want to be sure that every investment decision you make is the right one. So go on, what are you waiting for?

Find out more about the Types of ETFs in the next chapter.

Head back to the Ultimate Guide to ETFs

The table below displays some of the International Broad Based ETFs available on our database with the highest three-year returns (sorted highest to lowest by three-year returns and then alphabetically by provider name). Use Canstar’s ETF comparison selector to view a wider range of products. Canstar may earn a fee for referrals.

My Wealth Solutions LogoWritten by My Wealth Solutions, financial planning and advisory firm. 

This article was reviewed by our Content Producer Isabella Shoard before it was published as part of our fact-checking process.

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