ETFs have many appealing features for both long-term investors and short-term traders, although there are some potentially dangerous pitfalls to avoid for both investor types. Here are some of the main advantages, with a few caveats.
1. Diversification
Unlike individual stocks or bonds, many ETFs represent a basket of securities. For this reason, they can be an easy way for individual investors to build a well-balanced strategic asset allocation of stocks and bonds, as well as alternative asset classes, including commodities, real estate, and even currencies. ETFs can also be an effective way to fill a gap in a well-balanced portfolio or to make more targeted investment decisions—say, on gold, financial services stocks, or emerging market debt—without having to pick individual securities or commodities.
Caveat
Not all ETFs are successful in tracking their index (benchmark) closely. If you're using an ETF for exposure to a particular index and your ETF isn't tracking it closely, you might not be getting what you paid for. In addition, other ETFs have emerged with a narrower focus. They may give you access to varying styles, sectors, or regions, but can be limited in their diversification benefits. For example, some country-specific ETFs offer you exposure, but do so through a limited number of stocks associated with the ETF's corresponding country index.
2. Low cost
Expense ratios for many index ETFs are low compared to actively-managed mutual funds that focus on similar areas of the markets. The main cost advantage of index-based ETFs stems from the fact that they generally don’t attempt to outperform the market like actively managed funds or ETFs do. In investment terminology, index-based ETFs are all about beta (tracking the index), not alpha (outperforming the index), so fund companies don’t need to hire analysts to research the companies that are likely to outperform their indexes. Nor do ETFs have investment minimums or fees for early redemptions, although certain brokers may impose early redemption fees.
Caveat
Of course, on most ETFs you will pay a bid-ask spread (the difference in price between the market price for buying the ETF and the market price for selling the ETF), which can erode some cost advantage ETFs might have relative to mutual funds. Plus there's a trend towards more narrowly focused ETFs and actively managed ETFs, both have significantly higher expense ratios.
Last, some ETFs that hold less liquid positions can have wide bid-ask spreads, which can further add to the investment costs. In general, if you are likely to hold the ETF for only a short time, all other factors being equal, look for ETFs that have low bid-ask spreads, ideally those under 0.25% of the share price.
We will continue the discussion of next 3 pros of ETFs.