Pros and cons of exchange traded funds (ETFs)

If you’re thinking about investing in an exchange traded fund (ETF), it’s worthwhile knowing both the benefits and risks of doing so. Like any financial product, it’s your hard-earned money on the line, so it can pay to know what you’re buying.

ETFs are a popular investment vehicle that allows investors to build a diverse portfolio or gain exposure to certain sectors. There are many advantages to ETFs, especially when comparing the fees to managed or mutual funds. ETFs are considered to be lower-risk investments because they hold a basket of stocks, have high diversification and are low cost. For the majority of everyday investors, ETFs can make a great addition to your portfolio for diversity.

However, before you get started investing, there are a few disadvantages to consider. When it comes to returns and dividends, ETFs tend to follow an index so if there is downward movement, this could be reflected in the performance. In this article, we deep dive into the pros and cons you may wish to consider before purchasing.

Possible Advantages of ETFs

Cost-effectiveness

One of the major benefits of an ETF is its cost-effectiveness. The fund may invest in upwards of fifty different listed stocks, but you only pay one brokerage fee. An ETF may also have lower management fees than an actively managed fund.

Diversification

The second potential benefit is the diversification ETFs offer, both within a single asset type and in the range of funds available. As mentioned, an ETF typically invests in many stocks; a product that tracks the S&P/ASX 200 for example, may spread your money across the 200 companies which form the index. This potentially gives you considerable diversification from a single investment. And with the variety of ETFs on offer, you can either narrow your investment to one specific sector or spread your investment broadly, from international shares to bonds to commodities.

Convenience & transparency

Exchange-traded funds also provide benefits as investing in stocks. As an investor, you have access to all the features that are available to stock investors, including the option to short or use limit and stop orders, not to mention being able to buy and sell as you wish while the exchange is open. With ETFs featuring on an online exchange, it also means that investors can always see the value of their investment and the purchase process is fairly simple.

Possible disadvantages of ETFs

As with any financial product, there are risks associated with exchange-traded funds.

It will never exactly match the index

The management fees applicable to ETFs mean that your return on investment will never exactly match the index it tracks. The buy and sell price of your shares in the fund can also vary from the net asset value of the underlying index, reducing your return.

Volatility

Despite the diversification an exchange-traded fund offers, this does not make your investment immune to volatility in the market, and you can still suffer losses in a bear market. This risk can increase in line with the specialisation of the ETF – a fund that focuses on a small niche market is likely to be more volatile than a larger, broader one. For example, a fund tracking the mining sector is likely to be more volatile than one that follows the ASX 200.

Currency risk

Finally, if your ETF of choice invests overseas, fluctuations in the Australian dollar can impact your returns. Funds that offer exposure to emerging markets may also be more volatile. You may even be pinged by foreign taxes if the fund you invest in is located outside Australia.

→Read more: Risks and benefits of investing overseas

It is important to remember that this is only a brief overview of the benefits and risks of exchange-traded funds. As with any financial decision, it is always best to do your research and consider your own personal circumstances and tolerance for risk.

Originally authored by Tim Smith. 

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