What are the benefits and limitations of investing in ETFs? MintGenie explains (2024)

Exchange-traded funds (ETFs) can be likened to bundles of marketable securities, providing a wide range of exposure by tracking not just conventional benchmarks such as NSE, BSE, or Nifty 50, but also commodities including gold and silver, themes, and sectors. This adaptability renders them exceptionally versatile instruments for constructing comprehensive investment portfolios.

Similar to individual stocks, ETFs are actively traded throughout the day at market prices, unlike index funds that are bought and sold at their net asset value (NAV) only at the close of the trading day. Although ETFs usually have lower expense ratios compared to traditional mutual funds, their costs are slightly higher than those of index funds due to additional trading expenses. Many investors favour ETFs for potential tax advantages resulting from in-kind creation and redemption processes, which can help minimize capital gains distributions.

Benefits of investing in ETFs

Investing in an ETF offers numerous advantages, making it a favoured option for both beginners and seasoned investors. Here are some of the primary benefits:

Diversification: Instantly gaining exposure to a diversified set of underlying assets is a key benefit of a single ETF. Achieving such diversification through the individual purchase of stocks or bonds can be both challenging and costly. This feature helps mitigate overall portfolio risk by distributing investments across various sectors and industries.

Cost efficiency: Most ETFs generally boast lower expense ratios compared to actively managed mutual funds since they passively track an index instead of maintaining a team of analysts for selecting individual stocks. This results in enhanced long-term returns for investors.

Transparency: The majority of ETFs disclose their holdings daily, providing complete transparency regarding the components of your investment. This empowers you to make well-informed decisions about whether the ETF aligns with your investment objectives and risk tolerance.

Liquidity: These funds are actively traded on stock exchanges throughout the day, similar to individual stocks. This allows for convenient buying and selling of shares at prevailing market prices, offering increased flexibility compared to mutual funds, where buy and sell orders are executed only at the close of the trading day.

Tax efficiency: ETFs typically present tax benefits owing to their in-kind creation and redemption process. This mechanism has the potential to reduce capital gains distributions in comparison to traditional mutual funds, ultimately optimizing your returns.

Accessibility: A diverse array of ETFs spanning various asset classes, sectors, and themes provides the opportunity to customize your portfolio according to specific investment objectives and risk preferences. This adaptability makes ETFs accessible to a broad spectrum of investors, regardless of their experience and knowledge levels.

Minimal investment: Numerous ETFs feature comparatively modest minimum investment requirements, enabling accessibility for investors with smaller capital bases. This flexibility allows you to initiate the gradual construction of your portfolio and engage in market growth, even with limited funds.

Limitations of ETF investments

Similar to any investment, ETFs carry potential downsides. It is crucial to take these into account before making any investment decisions:

Reduced potential for returns: Due to their passive tracking of an index, ETFs may not exhibit significant outperformance of the market over the long term when compared to actively managed funds.

Short-term price fluctuations: The values of ETFs can vary during the day in response to market shifts, potentially resulting in increased short-term volatility compared to more stable investments.

Tracking discrepancy: Certain ETFs may not precisely mirror their underlying index, leading to a slight variance in performance.

In general, the advantages of investing in ETFs frequently surpass the disadvantages for numerous investors. Their diversification, cost-effectiveness, liquidity, and transparency contribute to their value as tools for constructing a comprehensive and efficient portfolio. Nevertheless, investors must conduct thorough research and select ETFs that align with their specific investment objectives and risk tolerance before making any commitments.

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Published: 05 Jan 2024, 02:49 PM IST

What are the benefits and limitations of investing in ETFs? MintGenie explains (2024)

FAQs

What are the advantages and disadvantages of investing in ETFs? ›

Advantages of Exchange Traded Funds
  • Advantages of Exchange Traded Funds. Diversification.
  • Liquidity.
  • Lower cost ratios.
  • Immediately reinvested dividends.
  • Lower discount or Premium in price.
  • Disadvantages of Exchange Traded Funds. Diversification is limited.
  • Intraday pricing could be excessive.
  • Dividend yields have dropped.
Apr 12, 2022

What are the 4 benefits of ETFs? ›

Positive aspects of ETFs

The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.

What is the primary disadvantage of an ETF? ›

The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.

What are the benefits of ETFs compared to stocks? ›

ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice.

What is the downside of investing in ETFs? ›

Key Takeaways. ETFs are less risky than individual stocks because they are diversified funds. Their investors also benefit from very low fees. Still, there are unique risks to some ETFs, including a lack of diversification and tax exposure.

What are the advantages and disadvantages of investing in an ETF vs a mutual fund? ›

Quick Reference Comparison
ETFsMutual Funds
PricingDetermined by marketNet asset value (NAV)
Tax EfficiencyUsually tax efficient due to less turnover and fewer capital gainsNot as tax efficient due to more turnover and greater capital gains
Automatic InvestingNot availableYes, for investments and withdrawals
9 more rows

Are ETFs a safe investment? ›

ETFs can be safe investments if used correctly, offering diversification and flexibility. Indexed ETFs, tracking specific indexes like the S&P 500, are generally safe and tend to gain value over time. Leveraged ETFs can be used to amplify returns, but they can be riskier due to increased volatility.

Are ETFs good for beginners? ›

The low investment threshold for most ETFs makes it easy for a beginner to implement a basic asset allocation strategy that matches their investment time horizon and risk tolerance. For example, young investors might be 100% invested in equity ETFs when they are in their 20s.

Should I put most of my money in ETFs? ›

You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all.

Can a ETF go to zero? ›

For most standard, unleveraged ETFs that track an index, the maximum you can theoretically lose is the amount you invested, driving your investment value to zero. However, it's rare for broad-market ETFs to go to zero unless the entire market or sector it tracks collapses entirely.

Why do ETFs lose value? ›

Bottom Line. Leveraged ETFs decay due to the compounding effect of daily returns, volatility of the market and the cost of leverage. The volatility drag of leveraged ETFs means that losses in the ETF can be magnified over time and they are not suitable for long-term investments.

Is it better to invest in stocks or ETFs? ›

Returns can be higher than ETFs: Even though stocks are generally a riskier investment, the returns can be greater, especially if the company is growing quickly. Commission-free trading options: There are many commission-free options that allow you to trade stocks without spending an extra penny.

What is the single biggest ETF risk? ›

The single biggest risk in ETFs is market risk.

What are the tax benefits of ETFs? ›

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold. Internal Revenue Service.

What is the point of an ETF? ›

ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.

Do ETFs have tax advantages? ›

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold. Internal Revenue Service.

Why ETFs are better than mutual funds? ›

Less paperwork equals lower costs. Most of the time. Transparency: ETF holdings are generally disclosed on a regular and frequent basis, so investors know what they are investing in and where their money is parked. Mutual funds, by contrast, are required to disclose their holdings only quarterly, with a 30-day lag.

How do you make money from ETFs? ›

How do ETFs make money for investors?
  1. Interest distributions if the ETF invests in bonds.
  2. Dividend. + read full definition distributions if the ETF invests in stocks that pay dividends.
  3. Capital gains distributions if the ETF sells an investment. + read full definition for more than it paid.
Sep 25, 2023

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