Exchange-traded funds (ETFs) have gained popularity among today’s investors. Like other investment products, ETFs have advantages and disadvantages. When considering whether ETFs are right for you, the answer likely depends on your individual long-term goals and financial situation. In other words, regardless of the advantages and disadvantages ETFs might offer, you should ask how well they match your financial goals and preferred investment strategy.
To determine if ETFs are appropriate for your portfolio, particularly if you are investing for retirement, it is important to understand these products and ask the right questions to determine if ETFs can help you. We will cover a few basics here, starting with a fundamental description of exchange-traded funds.
An ETF is a type of security that pools investor funds to invest in a basket of stocks, bonds or other assets. This structure is somewhat similar to how mutual funds operate. Unlike most mutual funds though, ETF shares trade openly on stock exchanges—hence the name “exchange-traded.” The shares can also be traded intraday, much like individual stocks. Because they can be traded intraday, their prices fluctuate throughout the day—unlike mutual fund prices, or net asset values (NAVs), which are normally calculated at the end of the trading day.
A number of features make ETFs an attractive alternative to mutual funds. Among them, ETFs often have higher daily liquidity, lower fees and offer an easy and convenient way to achieve market diversification or exposure to a particular sector or style. ETFs can also provide investors with a wide range of investment opportunities from domestic and international securities to currencies and commodities.
With the many different types of ETFs—leveraged ETFs, bond ETFs, commodity ETFs, currency ETFs and more—you might want to consider the following questions before investing in one.
When can exchange-traded funds offer benefits?
As a potentially low-cost and convenient way to achieve market diversification, ETFs may be a good product for those who have less money to invest. You can purchase a single ETF share that can provide exposure to a wide range of individual securities. But for high-net-worth investors who have the financial means to build a diversified portfolio of individual securities, ETFs may pose more limitations than benefits.
What are the true costs of buying and holding an exchange-traded fund?
Many ETFs are passively-managed index funds, which means they automatically track an index and do not have individual securities chosen by a manager. Since the individual assets that make up an index are rarely changed or rebalanced, commissions paid to the brokerage make up the bulk of the costs. Although ETFs have expense ratios and other fees associated with the fund’s operational costs, many tend to be minimal.
Some ETFs are actively managed, meaning the fund manager trades securities and modifies the portfolio’s allocations based on their market forecast. This kind of ETF could incur more transaction costs, which might be reflected through higher expense ratios and fees.
What are exchange-traded fund risks, drawbacks and limitations?
Your portfolio should align with your investment goals. Although many investors share the common goals of longer-term growth, increasing purchasing power or generating cash flow, ETFs may not be flexible enough to meet your needs if your investment goals change.
These funds are designed to serve a large and general group of investors and aren’t personalized to your individual needs. If your goals change, your ETF won’t change and may no longer be appropriate in your portfolio. You may have to find another ETF, a different investment or you may have to re-allocate your entire portfolio of ETFs differently to better align with your new goals. For example, if you require long-term growth, you might hold only equity ETFs. But if your situation changes and you now require more near-term cash flows, your ETF holdings won’t change to reflect this change unless you place the trades yourself.
In addition, what happens if you wish to exclude a few stocks or types of companies? You may wish to restrict certain companies from purchase or avoid investing in certain types of stocks based on personal concerns or beliefs. That may be impossible within a single ETF, let alone multiple ETFs. In this case, owning individual stocks might be more beneficial to your strategy.
How might owning ETFs affect my capital gains taxes*?
If you sell a stock that has declined in value, you have the option of harvesting a loss—using your capital loss to offset taxes on your capital gains and income. But you cannot sell a few stocks in an ETF. Instead, your only choice is to sell the ETF itself. If a certain stock that is held in an ETF declines in value, but the ETF itself does not, you cannot harvest that loss. For high-net-worth investors, this lack of flexibility to practice tax loss harvesting can make ETF ownership less tax efficient than owning individual securities.
*The contents of this document should not be construed as tax advice. Please contact your tax professional.
Are my ETF holdings over-diversifying my portfolio?
If you own more than a few ETFs, they could be overlapping by holding the exact same securities, identical positions for which you are paying additional expenses and commissions. Even worse, they can overlap in a way that over-concentrates your exposure to certain stocks, sectors or countries. This can introduce more risk into your portfolio and even defeat one of the fundamental advantages of owning ETFs in the first place—simple diversification.
Is ETF intraday liquidity truly an advantage?
Intraday liquidity can be an advantage or disadvantage, depending on what you do with it. Because ETF shares may be traded intraday, you could find yourself making more emotional investing decisions based on intraday price movements—not necessarily a good thing.
If your goal is to build a retirement portfolio, you may be tempted to trade or rebalance your portfolio when markets get rough. Market volatility can inspire fear, and fear can lead to emotional and shortsighted trades that contradict your long-term investment strategy Even experienced investors sometimes react to market fears. If you decide to incorporate ETFs into your portfolio, it is important to understand how you might react to intraday market volatility.
Alternatively, having an adviser to speak with during times of heightened market volatility can help. In this case, you can call your adviser when you think a trade is warranted and they can recommend a solution that doesn’t harm your long-term investment strategy. Though your adviser may advise against your trades at times, this is exactly what some investors need during volatile trading days.
There are many questions to consider before purchasing an ETF. An investment adviser can provide guidance on exchange-traded funds and whether they are appropriate for your situation. To learn more about Fisher Investment’s views on ETFs, other securities, and our current market outlook, please download one of our guides or contact us today.