The Pros and Cons of Using ETFs to Invest

If you want to build a well-diversified investment portfolio, you will hardly get around using exchange-traded funds (ETFs). That is hardly surprising because ETFs offer many advantages.

But in spite of their popularity, ETFs also have some disadvantages. In this guide, moneyland.ch covers the main positive and negative aspects of using ETFs to invest.

Pros:

Advantage 1: ETFs make diversification easy

ETFs let you invest in a whole basket of different stocks in one go, without having to buy each stock individually. ETFs that replicate global stock indexes, for example, can hold thousands of different stocks. That radically reduces the effort required to diversify your investment portfolio, and you can benefit from this diversification even if you do not have huge amounts of capital to invest. You can invest in ETFs starting from just a few francs.

Advantage 2: ETFs are usually cheaper than mutual funds

The overwhelming majority of ETFs are passively managed funds. A passively managed fund simply copies the makeup of its portfolio from an existing market index, without the fund’s managers having to actively choose what the fund should invest in. This labor-saving approach often results in passively managed funds having much lower fees than actively managed funds.

Additionally, active fund managers are rarely able to consistently generate higher returns over long terms. Passively managed ETFs and index funds are usually a better choice. Be aware though, that there are also actively managed ETFs.

Advantage 3: Investing in ETFs is easy

ETFs are simple and have high liquidity. You can easily buy and sell ETF shares during trading hours using a stockbroker. That makes investing in ETFs relatively uncomplicated. Tip: Comparing stockbrokers is recommended. There are huge differences in the brokerage and custody fees charged by different stockbrokers.

ETFs also make it easy to invest in other asset classes besides stocks. For example, there are ETFs that invest in precious metals like gold, silver, platinum, and palladium. There are also ETFs that invest in bonds and money market instruments. There are even ETFs that invest in cryptocurrencies like bitcoin and Ethereum.

Advantage 4: ETFs are transparent

Transparency is one of the key advantages of ETFs. You can track the daily performance of an ETF, and in many cases also the performance of its individual components. The fund’s fees are also clearly shown – usually as a total expense ratio (TER).

Cons:

Disadvantage 1: You pay ongoing fees

Unlike investing in individual stocks, using an ETF to invest generates ongoing costs in the form of fees charged by the fund’s managers. The fund’s annual fee is shown as its TER. The TER is deducted from the fund’s assets, which reduces the returns you earn on your investment.

The cheapest passively managed ETFs have TERs equal to less than 0.1 percent per year. Fees vary substantially depending on the index, theme, asset class, and investment strategy used by the ETF. It is advisable to compare fund fees when choosing an ETF to invest in. Depending on which asset class, it can also be cheaper to invest in the asset directly instead of through an ETF, although it often requires more effort.

Disadvantage 2: ETFs facilitate risky investment behavior

In principle, the simplicity of buying and selling ETF shares is an advantage. But it also has a negative side. The constant and simple tradability of ETFs can tempt nervous investors to sell their ETF shares again shortly after investing – when the value of their portfolio is in the red, for example. That is problematic because the potential returns of diversified ETF portfolios typically only come to fruition over a long investment term. ETFs are not designed for day trading, but as a basis for long-term investments.

Disadvantage 3: You do not have voting rights in the underlying companies

When you buy shares in a company and register as a shareholder, your shares normally entitle you to vote on key corporate decisions in the company’s annual general meeting.

That is not the case when you invest in stocks indirectly via an ETF. When you invest in an ETF, you only own shares in the ETF, but not in the stocks that the ETF invests in. The voting rights do not go to you, but to the legal owner of the shares – the fund’s operator.

Disadvantage 4: Not all ETFs are cheap

Associating ETFs with low costs is not entirely incorrect, but neither is it entirely correct. There are enormous differences between the fees charged by different ETFs. While low-cost ETFs can have TERs lower than 0.1 percent per year, there are also ETFs with TERs well above 0.5 percent. ETFs do not necessarily need to be passively managed. There are also actively managed ETFs.

It is important to exercise caution. Just because a fund has the term ETF in its name does not automatically mean that it has low fees. If there is more than one ETF for the index or theme you want to invest in, then you should make sure to compare them before you choose one to invest in. It can also be worth including ETFs that replicate similar indexes in your comparison.

Disadvantage 5: There is still a risk of loss

It is true that having a globally diversified stock portfolio – using ETFs, for example – greatly reduces the risk of loss compared to investing in just a few individual stocks. But that does not mean that you do not risk losing money. Returns can never be guaranteed at any point in time, and losses can never be completely ruled out. There is no way to predict future returns. Even past performance is no sure indicator of future performance.

Important: The amount of risk you take on when you invest in an ETF greatly depends on the size of the market and the region covered by the ETF. For example, an ETF that replicates the Nikkei 225 does enable a diversified investment in the Japanese stock market, but by investing in one country only, you expose yourself to the risk of negative developments in that country.

Disadvantage 6: Counterparty risk

Not all ETF operators actually buy the underlying assets. There are ETFs that use swaps to replicate an index or other benchmark. Swaps involve a third party that delivers returns and dividends indicated by the benchmark to the ETF’s operator. In exchange, the ETF provides collateral and pays fees for the service. You can learn more about the methods used for replication in the checklist for choosing an ETF.

If one of the two parties involved in the swap becomes insolvent, you as the investor will bear the counterparty risk. In the worst case, you may lose your entire investment. However, the actual chance of this happening is small, in part because regulations greatly reduce the risk.

Important: The information in this article is provided for educational purposes only, and should never be considered as investment advice. The publisher accepts no liability in connection with this article.

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Checklist for choosing the right ETF
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Common stock market preconceptions fact-checked
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