Published July 15, 2003

The Pros and Cons of ETFs!

Everyday, investors looking for the right addition to their portfolio are faced with an overwhelming number of choices. For many, exchange-traded funds (ETFs) are viable options. ETFs were created in an attempt to combine the diversity of a mutual fund with the trading flexibility of an individual stock. Traded on a major exchange, each ETF tracks a specific index, giving shareholders access to the stocks of the index. When deciding if an ETF is the right choice, investors must first weigh the benefits and disadvantages.

PROS

One of the most visible advantages of an ETF is exactly that for which it was designed: flexible diversity. Ranging from the broad-based S&P 500 Index to the sector-specific Dow Jones U.S. Utilities Index, an ETF is a basket of stocks that reflects the composition of its underlying index. Not only are investors given a wide variety of indexes, covering all corners of the market, from which to choose, but each ETF provides a diverse pool of companies within the index. For example, even a sector-specific ETF, such as StreetTracks Morgan Stanley Technology Index Fund, offers a diverse range of technology positions, from semiconductors, to Internet networking, to telecommunications and wireless equipment. Although this diversity can be found within many index mutual funds, ETFs can be bought and sold at intraday market prices. Most mutual funds are priced at their net asset value (NAV) following the close of the exchanges each day. The price of an ETF, however, fluctuates on a real-time basis, allowing investors to make transactions as they would with an individual equity, throughout the business day. Although this may seem less important to the longer-term investor, those looking to take advantage of the market's daily fluctuations may find it a necessary benefit.

Though the flexibility and diversity of an ETF will attract many investors, its low cost is another notable plus. First, and foremost, because it is listed on a major exchange and traded as any single equity would, sales loads are nonexistent for ETFs. Additionally, the annual expense ratios for most ETFs are lower than most other investment products, given the steady nature of the underlying indexes. Because they are index-based, incorporating a "passively" managed investment approach, ETFs are less likely to experience high management fees. Typically, an ETF manager will not make frequent portfolio changes—generally, he or she will make alterations only when the underlying index changes. Furthermore, the ETF's position on the exchange prevents the costs of having to buy or sell securities to oblige shareholder redemptions and purchases.

A third factor enticing investors to ETFs is their tax efficiency. Similar to index funds, ETFs are tax efficient due, again, to the consistency of the underlying index. The generally low turnover of securities within the indexes leads to fewer capital-gains tax consequences. At times, investors will be faced with capital-gains costs, such as the result of portfolio rebalancing following a change in the index, but they will not suffer these penalties from redemptions in the fund.

Investors looking to purchase ETFs may also take kindly to the opportunity for short selling and the ability to purchase shares on margin. Like a stock, investors can capitalize on an investment's downfall in the market by using borrowed shares, or shorting. Should an individual believe the market or sector embodied in the index is going to stumble, shorting its respective ETF could prove profitable if such a fall takes place. On the other hand, investors could also use borrowed money if necessary, buying an ETF on margin. This can enable investors to possibly increase profitability, by allowing them leverage to purchase a desired amount of shares that may have previously been unattainable.

But, with all these favorable reasons for purchasing an exchange-traded fund, why do some investors still shy away? When searching for the right ETF, investors will quickly realize, that there are some negative aspects to the investments.

CONS

Just as low expense ratios make ETFs more alluring to many investors, brokerage fees are what drive many away. Typically, only institutions and those willing to put up extremely high initial purchases can deal directly with ETF companies. As such, because they are purchased, like stocks, through a broker, investors must cough up fees every time any ETF-related transaction is completed. For those looking to phase in their investments in an ETF over time, or even in periodic installments, these costs begin to add up. Even less-active investors may be faced with unexpected costs, as the brokerage account in which they keep their ETF shares may be subject to annual fees.

Not only will brokerage fees cut into possible gains, but slippage on a bid-ask spread can also deplete returns. The bid-ask spread, in theory, allows for buyers and sellers to negotiate, setting up desired limits for purchases and sales. As ETFs allow for multiple transactions throughout a business day, however, the bid-ask spread can increasingly become a risk for some investors. For example, an investor may acquire an ETF at $20.125 per share, but then, turnaround and sell it for only $20.

Another downside to ETFs is that they do not necessarily trade at the net asset values of the underlying holdings. Because their trading is determined more by the supply and demand in the market, share prices can fluctuate somewhat independently of the respective index. What this means to investors is that they could potentially pay more than the index's worth to acquire an ETF, or possibly sell it for less.

An additional disadvantage brought on by their dependence on the supply/demand environment of the market, is the liquidity risks of ETFs. Shareholders of an open-end mutual fund can liquidate their position at any time, assured of NAV-linked prices. If the demand for units of a specific ETF is thin, however, an investor may not be able to liquidate the shares at the time desired. Some ETFs do offer an exit option to investors if no quotes on the ETF units are available for a specified number of days, but most impose an exit load, which, again, can exhaust gains.

Conclusion

Exchange-traded funds provide investors with an alternative option to investing in stock indexes. There are many positives that attract investors, just as there are disadvantages which encourage some to look elsewhere. Each investor has different goals, different finances, and a different threshold for risk. So before a decision is made, you must weigh the pros and cons and decide if ETFs are right for you.