Exchange Traded Funds (ETFs) – Pros and Cons

by KenFaulkenberry

in Portfolio Management

Exchange Traded Funds (ETFs)

ETFs - Pros and Cons For Value Portfolio Management

There are value investors who shy away from using exchange traded funds (ETFs). However, used correctly, these investment vehicles add a useful investment allocation tool to value portfolio management.

What is an ETF?

An Exchange Traded Fund (ETF) is an investment vehicle; a hybrid of mutual funds, and closed-end funds. ETFs hold a basket of assets such as stocks, bonds, or commodities; and trade on a market exchange so they can be traded anytime stocks trade. Most ETFs track a specific index and trade very close to their underlying value (net asset value).

ETF Advantages

ETF investing advantages are lower costs, instant diversification, liquidity, tax efficiency, sector investing, the ability to purchase in small amounts, and the availability of a wide variety of alternative, and even exotic, investments.

Lower Costs

Since ETFs trade like stocks, you can buy a diversified portfolio with the same low commission (typically $6 – $10) as a stock. Also, ETFs typically have lower expense ratios than mutual funds.

Instant Diversification

There are now hundreds of ETFs trading on U.S. stock exchanges. The variety is deep and wide, covering all major indices, sectors, industries, sizes (i.e. large cap, mid-cap, small-cap, micro-cap, etc.), strategies (growth, value, etc.), international (i.e. developed, emerging, and frontier markets), specific countries, and even exotic ETFs (commodities, short or bear funds, and leveraged funds).

There are also many ETFs in the income area. Bond ETFs include different terms (long, mid, short, etc.), various quality (treasury, corporate, high-yield, etc.) and regions (United States, individual countries, emerging markets, etc.).

Liquidity

ETFs trade on a market exchange so they can be traded (intraday) anytime stocks trade, not just at the end of the day. This can be an important benefit when volatility is high.

Tax Efficiency

Since most ETFs are not actively managed, but are programmed to follow a specific index, they don’t have capital gains and income that are required to be passed on to owners each year. This means investors won’t be taxed until they sell the ETF; giving them more control.

Sector Investing

ETFs can segment to very specific or targeted sectors of the economy. This allows investors to have  a diversified position in a small slice of a sector where they want exposure.

Can Be Purchased in Small Amounts

Since ETFs trade like stocks there are advantages for position sizing. Small positions can be purchased (no minimum investment) to scale in or scale out of a position, or take a single small position in a particular ETF.

Available in Alternative Investments

ETFs allow investors to take positions in alternative or even exotic investments that are unavailable in any other form to small investors. New products become available regularly and include ETFs in commodities, hedges, and leveraged long and short positions in indices and sectors.

Portfolio Hedging with Inverse ETFs

Portfolio hedging can be a potent risk management strategy. An inverse ETF is programed to move the opposite direction of a specific index. Inverse ETFs allow a portfolio manager to take the market risk partially or wholly out of an entire portfolio or specific segment of a portfolio.

ETF Disadvantages

In order to get the maximum benefit of investing in ETFs it is important to identify and understand two crucial disadvantages. Fortunately, these shortfalls can be mitigated if investors have a clear comprehension of the disadvantages, and how the solution can help optimize their portfolio.

Over Diversification

Many ETFs participate in over diversification. ETFs are generally not actively managed, but are programmed to follow a specific index. The index, and therefore the ETF, may not own the very best stocks.

It may be more advantageous to buy a limited number of the best companies rather than own the entire index. This would be particularly true with ETFs that track indices with a small universe of stocks such as a specific sector or industry.

Lack of Rebalancing

ETFs don’t rebalance their portfolios. Remember, most ETFs are programed to track an index. In an index, as the winners increase in price they become a larger percentage of an index. At the same time some stocks decline in price and become a smaller percentage of an index. By owning the index, or ETF tracking the index, you may own more of expensive over priced stocks and less of the bargain underpriced or value stocks.

Mitigating ETF Investing Disadvantages

Both of these disadvantages can be mitigated by investing in a combination of ETFs and individual stocks. There are circumstances that are appropriate for ETFs and circumstances that are appropriate for individual stocks.

Asset Allocation Investing and ETF Portfolios

In cases where the portfolio manager wants a small percentage allocated to a specific index, sector, industry, cap size, region, country, etc, an ETF is the perfect investment vehicle. Therefore, small positions and positions that benefit from a great deal of diversification are prime candidates for using an ETF as an investment vehicle.

In cases where the portfolio manager has a larger percentage allocated to an asset it might be beneficial to pick the very best stocks for that category. For instance, most portfolios should have a substantial allocation to dividend growth and income stocks. This might be a category that would be optimized by owning the best individual stocks instead of owning an index or ETF that would own both the good and the bad stocks in the index.

Using ETFs should be an investment vehicle option in value portfolio management. Used wisely they can be a valuable tool to lower risk and/or improve portfolio returns.

Related Reading: Mutual Fund Expense Ratio: How Much Does It Hurt Investment Performance?

Investing Principles Fundamental to Successful Outcomes


Written by KenFaulkenberry

KenFaulkenberry

AAAMP Blog by Ken Faulkenberry
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record.
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{ 2 comments… read them below or add one }

Dave Smith

Hi Ken. Thanks for the helpful post. Compared to stocks and mutual funds, ETFs are newer financial products. I have a couple follow-up questions about ETFs: 1) Are there any important regulatory differences between ETFs and mutual funds that investors should be aware of? 2) Are some ETFs less liquid than other ETFs, and, if so, how can investors judge ETF liquidity? Thanks! Dave

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KenFaulkenberry

Thank you Dave. There are differences between mutual funds and ETFs: Here is short post about this subject: http://wiki.answers.com/Q/What_are_the_main_differences_between_ETFs_and_Mutual_Funds Some ETFs are less liquid than others. This is similar to stocks. Investors should be sure the daily trading volume provides sufficient liquidity for trading. For most major ETFs this is not a problem.

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