Advantages and Disadvantages of ETFs

Identifying the advantages and disadvantages of ETFs can help investors decide whether these securities make sense for their portfolios.
Advantages and Disadvantages of ETFs
3 min
07-June-2024

ETFs are suitable investments for both long-term and short-term investors, including beginners. They eliminate the need for extensive research and expertise in individual stocks. Since 1993, exchange-traded funds (ETFs) have changed how we invest. Essentially, ETFs are a basket of securities that tracks and tries to outperform the underlying index.

This article explains the concept of ETFs and highlights their pros and cons to help you make better investment decisions.

Overview of ETFs

An ETF, or exchange-traded fund, works like a group fund you can buy and sell on the market, much like how you trade stocks. This is different from mutual funds in the way that mutual funds also pool money but are only traded once a day after the market closes.

ETFs can replicate a wide array of assets and can be made to follow specific investing plans, offering a varied way to manage assets.

Advantages of ETFs

Below mentioned are the advantages of investing in ETFs:

Diversification

ETFs expose investors to a broad range of securities that span several markets, industries, asset classes, countries, or stock market indexes, helping mitigate the impact of a single investment's bad performance on the overall portfolio.

Trades like stock

Unlike mutual fund schemes, ETFs are traded on exchanges at prices set by the market during the trading day. Investors have more freedom to complete deals when they can purchase and sell ETF shares in real-time. ETFs can be acquired on leverage, traded short, or utilised as the underlying securities for option contracts.

Lower fees

ETFs cost less because they don't need much management. They save money on fees for running the fund, paying managers, and other costs. This means investors can save more of their money in the long run.

Immediately reinvested dividends

ETFs put dividends right back into the investment. This means any money made is reinvested to grow the amount.

Limited capital gains tax

ETFs are smart with taxes, often causing less tax to be paid on profits. They don't buy and sell as much, so there are fewer tax bills for investors.

Lower discount or premium in price

ETF prices stay closer to the real value of the underlying assets. Market experts work to ensure the price you pay is fair, avoiding big price jumps or drops.

Disadvantages of ETFs

ETFs are popular investment vehicles, but they also have some disadvantages that investors should be aware of.

Less diversification

ETFs are designed to track a specific index or sector, which means they may not provide the same level of diversification as a traditional mutual fund or a diversified portfolio. This can lead to higher risk and volatility for investors.

Intraday pricing might cause unwise trading

ETFs are traded on stock exchanges like other securities, which means their prices can fluctuate rapidly during the trading day. This can lead to unwise trading decisions if investors are not careful, as they may buy or sell at the wrong price.

Costs could be higher

ETFs often have higher costs compared to traditional mutual funds, including management fees, administrative fees, and other expenses. These costs can eat into the returns of the ETF, making it less attractive to investors.

Lower dividend yields

ETFs are designed to track a specific index or sector, which means they may not provide the same level of dividend yields as a traditional dividend-paying stock. This can be a disadvantage for investors who rely on dividend income.

Skewed leveraged ETF returns

Leveraged ETFs are designed to amplify the returns of the underlying index or sector. However, these ETFs can also experience skewed returns, which means they may not always provide the expected returns. This can be a disadvantage for investors who are not prepared for such volatility.

Conclusion

ETFs offer benefits like cost-saving, easy trading, and diversification. However, it is important to consider the downsides, such as less variety and possibly higher trade costs. By carefully considering both sides, investors can make smarter investment decisions.

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Frequently asked questions

What is the downside to an ETF?

The downside to an ETF is that it can be subject to market volatility, potentially leading to rapid changes in value. Additionally, some ETFs may have limited variety or incur higher costs compared to other investment options.

Is it better to buy ETFs or stocks?

Whether it's better to buy ETFs or individual stocks depends on your investment goals and risk tolerance. ETFs offer diversification and lower costs, making them suitable for many investors. However, buying individual stocks allows for more targeted investments and the potential for higher returns, albeit with higher risk.

Is ETF better than mutual funds?

ETFs and mutual funds each have their advantages. ETFs often have lower fees, tax efficiency, and intraday trading capability, making them attractive for many investors. However, mutual funds may offer more hands-on management and broader investment options. The choice between ETFs and mutual funds depends on individual preferences and investment objectives.

What are the disadvantages of ETFs compared to mutual funds?

Disadvantages of ETFs compared to mutual funds include the potential for higher trading costs, limited diversification in some cases, and susceptibility to market volatility due to intraday trading. Additionally, certain niche or leveraged ETFs may incur higher expenses and carry increased risk compared to mutual funds.

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Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.