Why Investors Use ETFs

ETFs are known for being a flexible, convenient way to diversify your investment portfolio. Like any other investment vehicle, they also have their limitations.

The following is a non-exhaustive list of such advantages and disadvantages.

Some advantages:

  • Simplicity. ETFs are generally fairly easy to use. With just one transaction, an investor can create a highly diversified portfolio. There is no need to buy shares in individual companies because ETFs are an investment in an entire index.
  • Transparency. The price of an ETF roughly corresponds to a fixed percentage of the underlying index. To ensure tradability, it is usually one-tenth or one-hundredth of the level of the index. For example, if the level of the index is 500 points and one ETF relates to one-tenth of the index, the price of the ETF will be about € 50.
  • Differences between the price of an ETF and the level of the corresponding index may be due to accumulated dividends and management fees. The prices of ETFs that reinvest their dividend income differ more sharply from the level of the index.
  • Low cost. Buying ETFs allows an investor to obtain a diversified investment in an index, and pay nothing more than the normal transaction fees for a single share. Management fees for ETFs are typically low. On top of this, like stocks, most ETFs pay dividends.
  • Diversity. With just one transaction, investors can put together a diversified investment portfolio. ETFs offer investors the opportunity to invest in a favorite sector yet avoid the potentially negative effects a downturn in the market could have on a few individual stocks. ETFs can provide instant, diversified exposure by simply purchasing one security.

Some disadvantages:

  • Illiquidity. If an ETF is thinly traded, it can be difficult to exit the investment depending upon the size of your position relative to the ETF's trading volume. A sign of a thinly traded ETF is a large spread between the bid and ask prices.
  • Lack of control. Because an ETF tracks the performance of a specified index, you automatically gain exposure to the performance of every stock that comprises the index. You may be exposed to stocks you don't like that happen to be included in the index.
  • Commissions. ETFs may not be cost-effective if you are Dollar Cost Averaging or making continued purchases over time because of the commissions levied every time an ETF is purchased.