Exchange-traded funds (ETFs) are popular investment vehicles that allow investors to buy and sell a basket of securities, such as stocks, bonds, commodities, or currencies, on an exchange. ETFs offer many benefits, such as diversification, low costs, tax efficiency, and liquidity. However, they also have some drawbacks, such as tracking error, market risk, and trading fees.
Let’s explore the pros and cons of investing in ETFs in the long term with some simple examples to explain the concepts.
Diversification means spreading your money across different types of assets or sectors, which can reduce your overall risk and volatility. For example, if you invest in a broad-market ETF that tracks the S&P 500 index, you will own a small piece of 500 large-cap US companies from various industries. This way, you can avoid putting all your eggs in one basket and expose yourself to the performance of a single company or sector.
Another benefit of investing in ETFs in the long term is low costs. ETFs typically have lower expense ratios than mutual funds, which means they charge lower fees for managing the fund. For example, the average expense ratio for US equity ETFs is 0.44%, while the average expense ratio for US equity mutual funds is 1.25%, according to Morningstar data as of December 2020.
This means that if you invest $10,000 in an ETF with a 0.44% expense ratio, you will pay $44 per year in fees. In contrast, if you invest the same amount in a mutual fund with a 1.25% expense ratio, you will pay $125 per year in fees.
A third advantage of investing in ETFs in the long term is tax efficiency. ETFs are generally more tax-efficient than mutual funds because they generate fewer capital gains distributions. Capital gains distributions are taxable events that occur when a fund sells some of its holdings at a profit. ETFs tend to have lower turnover than mutual funds, meaning they trade less frequently and trigger fewer capital gains distributions.
For example, the average turnover rate for US equity ETFs is 40%, while the average turnover rate for US equity mutual funds is 63%, according to Morningstar data as of December 2020. This means that ETFs are less likely to incur capital gains taxes than mutual funds.
The first drawback of investing in ETFs for the long run is tracking error. Tracking error is the difference between the performance of an ETF and its underlying index or benchmark. Tracking error can occur due to various factors, such as fees, rebalancing, market conditions, or fund structure.
For example, if an ETF that tracks the S&P 500 index returns 10% in a year, while the S&P 500 index returns 11% in the same period, the tracking error is 1%. This means that the ETF underperformed its benchmark by 1%.
This is another drawback of investing in ETFs for the long term. Market risk is the risk of losing money due to fluctuations in the market prices of the securities held by an ETF. Market risk can be affected by various factors, such as economic conditions, political events, or natural disasters. For example, if an ETF that invests in emerging markets suffers a loss due to a currency crisis or political turmoil in one of its countries, this is an example of market risk.
The third drawback of investing in ETFs in the long term is trading fees. Trading fees are the costs associated with buying and selling an ETF on an exchange. Trading fees can include commissions charged by brokers, bid-ask spreads charged by market makers, and premiums or discounts charged by fund providers.
For example, if you buy an ETF with a $5 commission fee and a 0.1% bid-ask spread, and sell it with another $5 commission fee and a 0.1% bid-ask spread, you will pay $20 in total trading fees.
Investing in ETFs through a reputable platform like VT Markets provides additional advantages:
A: Yes, ETF trading is suitable for beginners. ETFs offer diversification, lower costs, and ease of trading. This helps new investors build a balanced portfolio without picking individual stocks. Additionally, VT Markets provides educational resources and demo accounts to help beginners learn before investing real money.
A: A good starting amount for ETF trading is around $500 to $1,000. This allows for diversification across several ETFs and keeps trading fees low. Ensure you have enough funds to cover potential losses.
A: The best strategy for ETF trading includes:
A: The main benefits include diversification, low costs, tax efficiency, and liquidity.
A: Tracking error is the difference between the performance of an ETF and its underlying index or benchmark.
A: VT Markets provides advanced trading tools, educational resources, and demo accounts to help investors make informed decisions and practice trading without financial risk.
A: Yes, risks include market risk, tracking error, and trading fees.
A: Open a demo account with VT Markets to practice trading with virtual funds and get a feel for the market.
Ready to start trading ETFs? Open a demo account with VT Markets today to practice trading without any money.
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