ETF Investment – What Are the Advantages and Disadvantages?

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This article considers what advantages and disadvantages ETFs offer the individual investor, and what other factors the individual investor should consider prior to making an ETF investment.

Advantages of exchange traded funds

ETFs offer the private investor a number of advantages. These include:

Market access:

As above, ETFs give investors unprecedented exposure to international stock markets, as they span nearly every available indexed equity class.

Cost:

ETFs are a cheap, efficient and direct means for investors to get exposure to equity markets. An ETF investment typically has low transaction costs (avoiding front-end charges, early redemption penalties or exit charges, and high service charges) and can be tax efficient.

Flexibility:

ETFs offer great flexibility for the individual investor, who is now no longer faced simply with the binary choice between direct stock ownership and diversification via mutual funds. The individual investor can trade in ETFs regularly, and can use ETFs in a variety of different ways.

Tradability/Liquidity:

As above, ETFs have stock-like features, as they trade throughout the trading day at prices that generally reflect their net underlying asset value (provided that there is minimal tracking error).

Disadvantages of ETFs

While ETFs offer a number of advantages to the individual investor, it is important to also note their potential disadvantages. These include:

Novelty/Liquidity problems:

As noted above, ETFs are a relatively new financial product, especially for small investors, and this has raised some concerns about their true liquidity (although some commentators have dismissed the liquidity concern by pointing to the size of the markets in which ETFs are traded.) Furthermore, there appears to have been some misinformation circulated in the market place concerning ETFs.

The potential for tracking error:

Some experts have claimed that the tracking error with ETFs (i.e. the difference between the price of ETF stocks and the true price of the asset/s they represent) can be substantial, leading to possible losses for the individual investor holding ETF shares.

Fund fees:

These may be substantial (depending on the fund).

Tips for ETF investors

Any individual thinking of investing in an ETF and in ETF trading should ensure that they understand the following:

Market fundamentals and investment goals

As with other types of investment, individuals thinking of investing in ETFs should ensure that they understand the fundamentals of the market, and that they have articulated their own investment goals and concerns. They should understand what risks attach to investing in ETFs (e.g. potential counterparty risks), as no investment is risk free. They should also get to grips with understanding what the underlying assets are that the ETF is seeking to «mirror».

The different types of ETF

Investors should understand that there are now a variety of ETFs on the market, and should consider which one/s suit their needs best. Beginners in the market may be best opting for ETFs that mirror commonly understood stock indices.

The need for risk management

  • Investors should seek to manage their risks by ensuring that they are happy with each ETF’s counterparty/ies.
  • As with other forms of investment, investors should try to ensure that their ETF portfolios contain the right assets and that they are sufficiently diversified.
  • Novice investors may wish to avoid «leveraged ETFs», given their potential for generating losses.

The need to avoid over-complexity

Novice investors especially would be well advised to keep their ETF investments simple, especially in light of the increasing complexity of ETFs in the market place.

The need for cost minimization

  • ETF costs can be minimised by using an online broker (which should keep commissions to a minimum).
  • Investors should also ensure that their ETF portfolios are low fee and tax-efficient.

The need for advice

As always, should they have any doubts, investors should consult a market professional who is experienced in dealing with ETF investments.

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