What are some ETF pros and cons? For many investors, an ETF is an easy way to invest in a wide variety of stocks. But there are some downsides.
ETF is an acronym for “exchange-traded funds.” Like stocks, you can trade them on the stock exchanges any time throughout the day. And like mutual funds, they contain a variety of stocks. And like both stocks and mutual funds, there are ETF pros and cons.
One of the pros is that, unlike individual stocks, an ETF has built-in diversification (usually – we’ll get to that shortly). And unlike mutual funds, the associated fees are limited, and there is no minimum investment amount outside of the share price.
Aside from these basics, there are actually many characteristics that give ETFs both pros and cons in comparison to other investments.
What is an ETF? Here’s your quick-start guide to understanding this investment option
One very simple way to understand ETFs, as compared to stocks, is to think of them as a Greek mezze platter. If you aren’t familiar, a mezze platter is a variety of dishes, such as hummus, stuffed grape leaves, feta cheese, olives, pita bread, and so on. The portions are smaller than you would get if you bought each menu item individually, but it’s also less expensive than buying a full entree of each item. You get to try a little bit of a lot of different foods.
An ETF is like that. Depending on the ETF you buy, you can get portions of shares in any number of companies. Traditionally, ETFs were designed to follow specific indexes. For example, there is an ETF that tracks the Dow Jones index called the SPDR Dow Jones Industrial Average ETF Trust (DIA). This ETF of 30 companies has $30 billion of assets, with an expense ratio of 0.16%. Other ETFs, like the SPDR S&P 500 ETF (SPY), track the S&P 500, and contain, as you can imagine, a selection of the 500 stocks in the index.
And in case you’re wondering, the mix isn’t even. Most ETFs, including these two, weight the holdings based, most often, on market capitalization. SPY, for example, has 5.52% of its assets in Apple (APPL), 5.28% in Microsoft (MSFT), 3.87% in Amazon.com (AMZN), and so on down the line.
But what is an ETF, if not an evolving investment avenue? From these ETFs and others focused very specifically on a particular index, you can now invest in an ETF in just about any sector you want. You could choose an ETF that highlights renewable energy sources and products, such as the iShares Global Clean Energy ETF (ICLN). You can opt for an ETF that tracks marijuana and marijuana-adjacent stocks, such as the ETFMG Alternative Harvest ETF (MJ).
ETFs aren’t just for stocks, though. The Vanguard Extended Duration ETF (EDV) holds U.S. Treasury securities. There are also highly specific commodity ETFs, such as the iShares Gold Trust (IAU), which “holds only gold,” according to their prospectus.
The ETF Pros and Cons
As you can probably guess, there are some ETF pros and cons here. The biggest benefit of an ETF is diversification. This is especially true with index ETFs, such as the SPY. However, not all ETFs are very diversified. If all your investments are in one industry or sector, you’re not going to be very happy when that sector falters. If you want to “diversify” within an industry, though, an ETF can be a great option.
The downside here is that you won’t get those big gains that come from an individual stock. You’ll get a part of that, of course, but it’s diluted since any particular stock is just a small portion of your ETF. The benefit of that is if one of the stocks in your ETF sinks, it won’t hurt your overall portfolio too much. So diversification is one of the ETF pros and cons, depending on how you look at it.
One other downside is that, like stocks, ETFs can lose value, especially highly-concentrated ETFs. You need to do your research just like you would when you invest in any stock.
What does this all mean? What is an ETF worth to your portfolio? Perhaps the most significant benefit of an ETF is that it can give you exposure to an industry or index when you don’t feel like any one or two stocks stand out.
What are your thoughts on ETF pros and cons? Do you find them to be helpful way to get into a variety of stocks or do they spread the benefits too thin?