Exchange-traded funds (ETFs) are a powerful type of investment.
ETFs offer certain advantages over other types of investments such as individual stocks or mutual funds.
ETFs aren’t all good. There are a few drawbacks, as well.
If you want to, you could compose an ETF-only portfolio. But is this a smart move? It depends on your goals.
Here are the pros and cons to consider before choosing to build a model portfolio with only ETFs.
What Is an Exchange Traded Fund?
An exchange-traded fund is a group of investments bundled together under an entity.
When you buy shares of an ETF, you’re buying a part of that entity and in turn, the investments it owns. Many consider it to be "mutual funds that are traded like stocks."
Each ETF has its own investment goals.
One ETF may aim to mimic the S&P500 index while another ETF may choose to try to imitate another index. Generally, ETFs follow a benchmark or create a benchmark to follow.
ETFs can hold a wide variety of investments including stocks, bonds, and commodities such as gold.
ETFs are traded on exchanges, like the New York Stock Exchange, throughout the day. This is very similar to how stocks are traded.
Like with any investment, ETFs offer certain benefits and drawbacks you should consider.
Pros vs. Cons of ETFs
|Lower expense ratios||Trading costs to consider|
|Diversification (similar to mutual funds)||Investment mixes may be limited|
|Tax efficiency||Partial shares may not be available|
|Trades execute similar to stocks|
An ETF-only portfolio does have some benefits over other types of investments.
Relatively low-cost investing
Due to the way ETFs are structured, they tend to have lower costs than certain other types of investments such as mutual funds.
For the most part, ETFs try to mimic and index which means the investment managers are fairly hands-off. Most aren’t actively managed.
The ETF managers aren’t trying to buy and sell stocks to gain an edge on the market.
Instead, they’re only buying and selling what’s needed to keep the ETF tracking its intended investment mix.
While a slightly lower cost may not seem like a big deal over a year or two, it’s a big deal over decades.
If two investments are exactly the same except for the cost, the investment with a lower cost will provide a larger nest egg. Each year, the lower-cost fund has more money left to earn future returns.
The compounding effect results in a major difference at the end of decades.
Exchange-traded funds typically offer fairly diversified investments.
Some aim to offer exposure to the total stock market, like Vanguard’s Total Stock Market ETF (VTI).
A diversified portfolio is important because you don’t want all of your eggs in one basket. If your money is in a single stock and that company goes under, you’re left with nothing.
An ETF may hold tens, hundreds or thousands of different types of investments within it. While you don’t want to go overboard, you can successfully spread out your investment risk with sometimes one or a few ETFs.
Some ETFs follow mimic indexes like the S&P 500. This is called index investing and gives you exposure to the whole S&P 500 index by buying a single ETF. Without investments like ETFs, you’d have to purchase hundreds of stocks to be as diversified as the S&P 500.
While some ETFs may focus on a particular sector, they’re still usually diversified across many companies within that sector.
That said, you do need to make sure you understand what your ETFs invest in.
Exchange-traded funds offer a more tax-efficient way to invest than mutual funds.
Because most ETFs are focused on passive or index investing, there aren’t as many trades that take place compared to actively managed mutual funds.
These trades cause capital gains and losses in mutual funds which are then distributed to mutual fund holders.
These distributions are taxable if the mutual funds are held in a taxable investment account.
Due to the indexing nature and the way ETFs work, capital gains, and losses are much smaller which helps lower your tax burden until you’re ready to sell your ETF shares.
Traded on exchanges
Mutual funds, a common alternative to ETFs, only trade once per day.
ETFs, on the other hand, trade throughout the day on the exchanges.
This is a huge difference for those that want more control over how and when they invest.
Let’s say there is a large event in the market that causes investments to drop drastically throughout the day.
If you want to be buying and selling at a particular time during that day you can do so with ETFs. With mutual funds, your transaction will end up taking place at the end of the day.
This can give you an advantage over mutual funds if you plan to time the market, although timing the market generally isn’t advised for long term investors.
Only using ETFs in your portfolio does limit you in certain ways. Here’s what to watch out for.
ETFs still have costs to consider
When you buy or sell an individual stock or bond, you pay a trade fee.
Once you pay the trade fee, you can hold the stock or bond without incurring any more expenses in most cases.
You may also have to pay similar fees when you buy or sell ETFs depending on which ETF you invest in and which brokerage firm you use.
ETFs have to be managed, as well.
That management, however small it is, does cost money. Most ETFs have expense ratios that are charged to cover these costs.
The costs ETFs charge may be small, but they do exist.
Not all investments are available
ETFs usually give you a pretty good set of investments to choose from, but you won’t be able to invest in everything using an ETF.
While developed markets might have a large selection of bond ETFs, stock ETFs and any other type of ETFs you can imagine, emerging markets may not offer the same selection.
Additionally, there are other types of investments you may want to make that don’t belong in ETFs.
If you want to buy a particular rare collectible car or piece of art, an ETF won’t be able to make that happen.
Harder to pick investments or investment mixes
Some people like to be extremely hands-on with their investments. Others have particular companies or asset classes they won’t invest in based on sustainability or their values.
For instance, some people refuse to invest in companies that sell meat products or companies that sell cigarettes.
Finding ETFs that invest based on your very specific investment goals may be difficult. ETFs may contain stocks in certain companies you don’t want to own.
Because of their wide-reaching ability, you might end up owning certain investments in multiple ETFs.
This may lead you to believe your asset allocation is different than it actually is. It may also expose you to the risk of overexposure to certain companies or investments.
For that reason, it’s important to understand what you’re investing in within each ETF. Then, you can evaluate your investments as a whole to make sure you’re getting the proper exposure you want.
Partial shares may not be available
Depending on the brokerage firm you use, you may not be able to buy partial shares of ETFs. While this may not be a big problem, it can make investing more complicated.
If you want to invest $500 every paycheck with a brokerage that doesn’t allow partial ETF investing, you’ll have to calculate how many whole shares you can buy with the money you have available.
Any money left over would have to be set aside until your next paycheck when you’d have to calculate how many shares you could buy at the next paycheck’s prices.
On the other hand:
Mutual funds do allow you to buy partial shares, so you could simply invest $500 each week with no problems at all.
If you plan to invest in ETFs and the ability to purchase partial shares is important, check to see if partial shares are available with the brokerage firms you’re considering before you open an account.
Alternatives to ETF Investing
Investing in ETFs isn’t your only option. Depending on your situation, you can invest in many other ways.
Individual stocks and bonds
First, you can buy individual investments such as stocks and bonds. This usually requires more research and time commitment after the purchase to monitor these investments.
In most cases, you don’t pay ongoing management fees for individual stocks and fixed income investments you own unless you’re using a financial advisor.
Mutual funds aren’t as nimble as ETFs, but they may be a better fit for certain investors and for certain investments.
You can also put your money in other types of investments such as real estate, art, collectible cars or anything else you want.
Some of these types of investments aren’t available through ETFs.
You Don’t Have to Choose All ETFs or No ETFs
Thankfully, there’s no rule stating you must stick to an ETF-only portfolio or a portfolio of other types of investments.
You can choose whatever makes the most sense for your situation.
If an ETF portfolio meets your needs today, you can set one up.
If things change and it no longer makes sense, you can sell whichever ETF shares you need to and buy something else.
While ETFs definitely have certain advantages over other types of investments in certain cases, don’t get caught up in the hype of having an ETF-only portfolio.
Instead, pick each investment by comparing all suitable options to find the best investment for you.
If you’re having trouble deciding whether and ETF-only portfolio is a good idea for you, consider speaking with a fee-only hourly fiduciary financial planner.
You can pay these professionals for their time rather than commissions so you get an unbiased opinion that isn’t focused on bringing your assets into the firm.