Editor's Note: This story originally appeared on NewRetirement.
If you do not know about exchange-traded funds (ETFs), it may be well worth your while to learn about them. There are many compelling pros and cons of ETFs as a retirement investment.
ETFs have become a very popular investment vehicle, and they can be a good place for retirement savings. In a nutshell, ETFs can be a low-cost way to ensure adequate diversification for retirement assets.
But first, what is an ETF really?
ETFs are often defined as a mutual fund that trades like a stock (on an exchange), and this is a good way to think about ETFs — assuming you have a crystal clear understanding of mutual funds and stocks.
Perhaps a comparison of mutual funds, index funds, and ETFs will help clarify how each investment works, and then we can dive into the pros and cons.
Mutual funds are a way to invest in a portfolio of different investments — usually stocks, but a fund could also include bonds and other types of securities.
Typically, mutual funds are managed by a professional adviser, and the idea is that this expert can buy and sell investments to get investors the best return for their money.
The goal of most mutual funds is to outperform a widely followed index like the Standard & Poor’s 500. So, if the S&P 500 saw a 1% increase, the mutual fund would want at least a 1.1% increase.
Most mutual funds charge fees, usually around 1% of the assets you have invested in the fund annually. This is typically explained as going towards operating costs and a premium for the fund adviser’s expertise.
An index fund is a kind of mutual fund designed to mimic the rise and fall of an overall market index. The most popular index funds track the S&P 500.
An index fund typically buys and holds rather than trading frequently.
And, the reality is that these index funds often offer better returns than a professionally managed mutual fund with a significantly lower annual fee (expense ratio).
How are they weighted? By market capitalization, which is the price per share times the number of shares that exist. Larger companies (e.g., Apple, Microsoft, etc.) are represented in a greater proportion than smaller companies.
ETFs are very similar to index funds in that they enable you to invest in a preset group of investments — most often an index. The difference between an ETF and an index fund is the way they are traded. You can purchase an ETF in the same way you purchase stock, and the costs of ETFs can be quite low.
There are many pros and cons of ETFs — mostly pros (at least for ETFs tracking a major index).
Pro of an ETF: Diversification
One of the key goals of any good asset allocation strategy is diversification — being invested in a variety of asset classes and a range of companies within each asset class.
ETFs can be the ultimate in diversification, allowing you to have broad exposure to a predetermined set of assets, as opposed to holding individual stocks.
With most ETFs, investors can see the underlying portfolio daily. Mutual funds are only required to report their holdings a couple of times during the year.
Pro: Trade Like Stocks
Just like individual shares of stock, ETFs can be bought and sold during the day while the stock exchange is open. Mutual fund orders must be submitted before the close of the market (earlier in the day for some funds) with the purchase or sale occurring after the close of trading for that day.
While there are distinct disadvantages to day-trading and market timing, it is nice to be able to get in or out of an ETF as needed.
This also means that market orders such as stop orders, limit orders, and others can be placed on an ETF to trigger a trade if the price hits a certain level.
This is the same as with shares of individual stocks. ETFs can also be sold “short,” a bet on a price decrease. You can even buy or sell options against ETFs, even if it most probably isn’t a smart move.
Pro: Cheap to Own
Many ETFs are very cheap to own. This is especially true with a number of index ETFs such as:
- Vanguard Total Stock Market (ticker VTI) has an expense ratio of 0.04%.
- Spider S&P 500 Index ETF (SPY), one of the oldest and largest ETFs, has an expense ratio of 0.09%.
This can make low-cost ETFs a good idea for long-term investors and a good vehicle for retirement investing. Fees and expenses are a critical factor in your long-term investing success, and low-cost ETFs can play a role.
Note: Not all ETFs are low in cost. You will need to research this and other aspects of any ETF that you may be considering.
Pro: Low Minimum to Invest
Mutual funds (even index funds) typically have a minimum buy-in investment, usually in the four-to-five-figure range. For those of us just starting to invest — or who don’t want to invest up to that rather-high minimum — traditionally, we’d be out of luck.
Enter ETFs. Now the minimum investment is just one share. With certain brokerage houses, you may even be able to buy a fraction of a share to start with!
Pro and Con of an ETF: They Can Go Beyond the Stock Indexes
Passive index ETFs that track benchmarks like the S&P 500, the Russell 1000 and 2000 indexes, the Barclays Aggregate Bond Index, and other widely followed stock and bond indexes are probably the most prevalent types of ETFs.
However, with interest in ETFs on the part of both the investing public and institutional investors, the number of types of ETFs have proliferated. There are now ETFs that:
- Are actively managed
- Follow alternative investment strategies
- Are comprised of bonds
One of the areas of growth in ETFs in recent years is in “smart beta ETFs.” Essentially these are ETFs that start with an index but then specialize in a specific investing goal or type of company. Common types of smart beta ETFs include:
- Dividends — companies within an index that are more likely to pay out dividends
- Quality momentum
- Size (for example small cap)
- Low volatility
- And others
Pro: The growing diversity of different kinds of ETFs is positive in that you can find an option that best suits your investing needs.
Con: The diversity is also a negative in that it can cause confusion and some of the real original benefits of an ETF — a low-cost and simple way to own the entire market — can be lost.
As always, know exactly what you are investing in and understand the fees that are built into the investment.
Pro and Con: Liquidity
Liquidity pertains to the ability to readily trade a security at or near its market value. Some ETFs have a lot of liquidity. Others do not.
Pro: ETFs that have a high daily trading volume and that track popular indexes like the S&P 500 will not have an issue with liquidity. You will likely be able to sell the investment when you want to.
Con: Some ETF asset classes, such as bonds, are not as liquid. For bonds and other asset classes — such as commodities, real estate, and some foreign securities — ETFs may be more difficult to sell exactly when you want to.
Pro and Con: Regulatory Structures
FINRA states that “Most ETFs are registered with the SEC as investment companies under the Investment Company Act of 1940, and the shares they offer to the public are registered under the Securities Act of 1933. Some ETFs that invest in commodities, currencies or commodity or currency-based instruments are not registered investment companies, although their publicly-offered shares are registered under the Securities Act.”
Be aware of exactly what you are buying and how it is regulated.
Con of an ETF: Again, You Need to Be Aware of What You Are Buying
With the proliferation of different kinds of ETFs, you need to be aware of what you are buying.
The Securities and Exchange Commission (SEC) advises, “Certain ETFs can be relatively easy to understand. Other ETFs may have unusual investment objectives or use complex investment strategies that may be more difficult to understand and fit into an investor’s investment portfolio. For example, ‘leveraged ETFs’ seek to achieve performance equal to a multiple of an index after fees and expenses. These ETFs seek to achieve their investment objective on a daily basis only, potentially making them unsuitable for long-term investors.”
Con: Bid-Ask Spreads
Without getting too technical, bid-ask spreads occur when a seller is willing to part ways with their goods for an amount lower than what a buyer is willing to pay for it.
This occurs with stocks being traded on an exchange. Let’s say you are willing to buy the stock XYZ for $10, and someone else is willing to sell XYZ for only $8. Your broker will buy XYZ for $8 from the seller, and then go to you and sell it to you for your offered $10, pocketing the $2 difference.
This happens with ETFs as well as with stocks. However, since mutual funds are only settled once a day (and not continuously throughout the day, as with stocks and ETFs), bid-ask spreads are far less pronounced with mutual funds.
Con: Intra-day Peaks
As with stocks, you may buy an ETF at just the wrong moment when the value shoots up for a minute.
Or conversely, when you sell, you may sell at just the wrong moment, when the price drops.
Although there may be steps you can take to reduce the chance of this, mutual funds (being settled once a day) are not subject to intra-day peaks.
Con: You Might Get Caught With Capital Gains
Some, but not all, ETFs will distribute capital gains to shareholders. This can trigger capital gains taxes, causing an unwanted tax liability.
It is usually better to choose an ETF that reinvests capital gains.
Make sure you know how your ETF deals with capital gains and be prepared for it.
Con: Your Money Is Not Safe From Market Losses
While there are some ETFs of bonds and other fairly stable investments, most ETFs are still essentially well-diversified investments in the stock market, which is not without risk.
Be aware that if you own an ETF that tracks the S&P 500 and the entire market crashes, then your ETF crashes as well.
Con: Watch Out for Trading Commissions
It depends on your brokerage, but every time you buy or sell an ETF, you will likely be paying a trading fee. For buy-and-hold investors, this is not a big deal, but something to be aware of.
If you yourself are actively trading ETFs, then pay attention to commissions.
Should I Consider an ETF as Part of My Retirement Plan?
The answer to this question will vary by person and will depend upon your investment objectives and other considerations that should go into the selection of any investment vehicle for retirement. Any ETF that you might be considering should be fully evaluated for its fit with the rest of your portfolio.
The pros and cons of ETFs are well defined. In summary, the pro is that many index ETFs are low-cost and have a straightforward investing style. However, the main con is that there have been a proliferation of ETF options and you need to:
- Know what is in your ETF.
- Consider carefully how much exposure you want to various asset classes. (Learn more about the bucket strategy as a way to optimize your investment risk and reward for retirement.)
ETFs can be mixed and matched with mutual funds, individual stocks, bonds, or any other investment vehicle in building a portfolio. Retirement investors can certainly consider ETFs if appropriate for their needs.