An Exchange Traded Fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset but is traded on a stock exchange. An ETF is similar to a mutual fund but trades like a stock and is not typically actively managed. ETFs can be a great inclusion in any portfolio and for that reason I will be discussing some risks and benefits of ETFs.
One of the many benefits of ETFs is the diversification potential. ETFs are pooled investments which means that they offer diversification within your portfolio. We talk about the importance of diversification within your portfolio all the time. For this reason ETFs can be used to build an entire portfolio or complement your other investments. If you lack exposure in certain sectors of your portfolio broad based ETFs can provide a solution. A second benefit to ETFs are their low cost. Most ETFs are passively managed, lowering the cost to the consumer. A typical ETF is not attempting to outperform a benchmark which means it requires less resources than a mutual fund. Thirdly, ETFs offer greater tax efficiency. ETFs pay less capital gains taxes for a few reasons. They are passively managed and therefore less holdings are sold resulting in less capital gains. ETFs are created by Authorized Participants. Authorized Participants create and redeem shares using in-kind transfer (transferring assets as-is) rather than a cash transfer, this contributes to tax efficiency. While ETFs do have greater tax efficiency compared to a mutual fund they still do pay capital gains tax. Lastly, ETFs offer transparency. ETFs disclose their holdings on a daily basis, in comparison to mutual funds who disclose their holdings but typically on a quarterly or semi-annual basis. Mutual funds do not disclose their holdings as often as they do not want to give others an intellectual advantage. Mutual funds are attempting to track or outperform the benchmark while ETFs are not.
As with any investment there are risk associated with purchasing ETFs. The two risks I will be discussing are liquidation and failure to reach the benchmark. Firstly, liquidation. When you purchase an ETF there is a risk that it will close at some point. If an ETF closes the funds within the ETF must be liquidated. This leads to taxable distribution and reinvestment cost to the consumer. The risk is much higher with ETFs that have a small amount of assets under management or ETFs that are issued by small providers. Secondly, failure to reach the benchmark. ETFs should not be expected to outperform the benchmark because they are not actively managed to increase profitability. Not all ETFs are built the same but these risks are important to keep in mind. It is important to do your own research and understand the ETFs underlying holdings.
ETFs are a great way for self-directed investors to build their investment portfolios. They allow investors to own a diversified set of securities. Whether an active or passive investor ETFs should be considered in your portfolio.