Advantages of Exchange-Traded Funds (ETFs) (2024)

Exchange-traded funds (ETFs) were created to combine the best characteristics of both stocks and mutual funds into a combined investment structure. They'll ideally leave out some of the less desirable ones. They have some drawbacks, however. No investment vehicle is perfect for everyone.

Key Takeaways

  • ETFs offer easy access to a diversified portfolio of assets.
  • They're traded on stock exchanges throughout the trading day, providing investors with the flexibility to buy or sell shares at market prices.
  • ETFs typically have lower expense ratios compared to mutual funds because they're more passively managed.
  • They disclose their holdings daily, allowing investors to see the underlying assets and make informed investment decisions.
  • There are a few downsides to ETFs to be mindful of as well.

Understanding ETFs

ETFs have characteristics of both mutual funds and individual stocks. Their primary purpose is to provide investors with a convenient way to achieve diversification. ETFs typically track a specific index, such as a stock market index. The underlying principle of an ETF is to replicate the performance of this chosen index rather than actively manage its holdings.

ETFs are mandated to disclose their holdings daily. This grants investors visibility into the assets held within the fund. ETFs are also more passively managed compared to other forms of investments such as mutual funds. This has its advantages although there are some downsides as well.

ETFs are popular and include more diversified offerings as time goes by. The U.S. Securities and Exchange Commission approved 11 new spot market bitcoin ETFs in January 2024 to be listed on the NYSE Arca, Cboe BZX, and Nasdaq exchanges. They're the first spot market bitcoinETFs ever to be offered.

ETFs can be used to target specific sectors, themes, or asset classes. They can also be used to cover different types of markets such as equities, fixed-income securities, commodities, or alternative investments.

Advantages of ETFs

Tax efficiency and liquidity are some common advantages that ETFs have over mutual funds, but the list doesn't stop there.

Tax Efficiency

ETFs can minimize capital gains distributions through the creation and redemption processes. This strategy is not available for mutual funds.


ETFs are traded on stock exchanges at market prices throughout the trading day. Investors can buy or sell shares when the market opens or throughout the day. Mutual funds typically trade at their net asset value (NAV) at the end of the trading day so traders have to wait until the market has closed before the mutual fund can be repriced and traded.

Lower Expenses

ETFs are usually passively managed. The portfolio manager sets the fund and then has a greater hands-off approach to managing it compared to a mutual fund manager. ETFs generally have lower expense ratios compared to mutual funds because the ETF manager is spending less time overseeing the fund but this is only as true as the level of passiveness of the fund manager.


ETFs usually have to provide a daily disclosure of their holdings so investors are rarely left in the dark about what the ETF holds. This transparency can be very important to some investors. It can help them make smarter decisions based on what they're holding. Mutual funds typically disclose their holdings less frequently and this makes it more difficult for investors to gauge exactly what is in their portfolios.


ETFs are designed to offer diversification by tracking a particular index or asset class. An investor can access a broad range of assets without having to worry about buying a lot of different stocks or security products. Investing in an ETF can reduce risk compared to buying just a single stock. Be mindful that the underlying components of an ETF may still be correlated, however. This is especially the case if they're all related to the same industry, such as an ETF that invests in commercial real estate.

No Minimums

Many ETFs have no minimum investment requirements so they're widely accessible to investors, especially those who are just starting without a lot of upfront capital to invest. This accessibility allows new investors to test the waters in a low-stakes environment. There may be fewer requirements to meet because there are no minimums and this can allow a new investor to more easily get started.

Authorized participants in an ETF can buy and redeem shares straight from the ETF but they can only do this in very large chunks. The SEC cites 50,000 ETF shares as an example.

Drawbacks to ETFs

ETFs come with a wide range of benefits but there are also some downsides to consider.

Intraday price volatility and bid-ask spreads may occur because ETFs can be traded during the day. This gives investors flexibility in trading their ETF exactly when they want but it also creates some price instability. Everyone else can buy or sell whenever they want as well.

Some ETFs can be complex and carry higher risks, particularly leveraged and inverse ETFs. This requires a thorough understanding of their strategies. Leveraged ETFs simply magnify the potential return of another ETF, posing a greater upside but also a greater downside to an investor. Inverse ETFs attempt to take the opposite position of something and bet on the inverse of that index to be successful.

ETFs are typically passively managed. They aim to replicate specific indexes. ETFs may make a little less money as a result because their goal isn't necessarily to maximize profits.

Examples of Widely-Traded ETFs

Some ETFs are more heavily traded than others. Those that top the list include:

  • The SPDR S&P 500 (SPY) is the most widely known ETF. It tracks the S&P 500 Index.
  • iShares Russell 2000 (IWM) tracks the Russell 2000 small-cap index.
  • Invesco QQQ (QQQ) tracks the Nasdaq 100.
  • The SPDR Dow Jones Industrial Average (DIA) tracks the Dow Jones Industrial Average which includes 30 stocks.

How Do ETFs Offer Liquidity to Investors?

ETFs trade on stock exchanges like individual stocks. They're bought and sold at market prices throughout the trading day. This liquidity provides investors with the ability to enter or exit their positions quickly because there's a ready market of buyers and sellers.

What Are the Benefits of ETFs for Long-Term Investors?

Long-term investors can benefit from ETFs in several ways. Their cost efficiency and low expense ratios can contribute to better returns over the years. The tax advantages of ETFs, such as minimizing capital gains distributions, also make them a tax-efficient choice for long-term investing.

Are There Any Potential Downsides to ETFs?

ETFs can be subject to intraday price volatility because they can be traded during the day. Some ETFs can be complex and carry high risks, particularly leveraged and inverse funds. ETFs are also usually passively managed so they may not be suitable for investors who prefer active management with higher earning targets.

What Is Tracking Error in ETFs?

Tracking error represents the deviation between an ETF's performance and the performance of its benchmark index. This discrepancy can occur due to factors such as management fees, dividend reinvestment, or the bid-ask spread.

Tracking errors are typically small but they're important for investors to consider when evaluating an ETF's performance relative to its benchmark. Investors aren't necessarily trying to maximize their return when they're investing in ETFs. They're trying to get a performance as close to a specific index as possible.

The Bottom Line

ETFs offer numerous advantages including diversification, liquidity, and lower expenses compared to many mutual funds. They can also help minimize capital gains taxes. But these benefits can be offset by some downsides that include potentially lower returns with higher intraday volatility.

Advantages of Exchange-Traded Funds (ETFs) (2024)


Advantages of Exchange-Traded Funds (ETFs)? ›

Positive aspects of ETFs

What are the advantages of investing in an exchange traded fund ETF? ›

7 Key Benefits of ETFs
  • Portfolio Diversification. ETFs provide one of the easiest ways to diversify a portfolio. ...
  • Wide Variety of Investment Choices. As the ETF industry has exploded, so too has the number of market exposures available within ETFs. ...
  • Low Cost. ...
  • Added Liquidity. ...
  • Transparency. ...
  • Trading Flexibility. ...
  • Tax Efficiency.

What is ETF advantages and disadvantages? ›

Advantages and disadvantages of ETFs

Investing in ETFs helps to mitigate unsystematic risks due to its passive investment strategy. It also lowers one's overall investment risk. It greatly helps with portfolio diversification. With the limited role of fund managers, ETF investments are comparatively cost-effective.

What are two facts about exchange traded funds ETFs? ›

1. An ETF provider considers the universe of assets, including stocks, bonds, commodities or currencies, and creates a basket of them, with a unique ticker. 2. Investors can buy a share of that basket, just like buying shares of a company.

What is an advantage to investors of exchange traded funds ETFs that is not available to investors in mutual funds? ›

An advantage to investors of exchange traded funds (ETFs) that is not available to investors in mutual funds is that ETFs are run by professional money managers. Investors can sell short ETFs. ETFs can only be purchased and redeemed through an investment company resulting in stable prices.

What are the 4 benefits of ETFs? ›

Positive aspects of ETFs

The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.

What are the benefits of ETFs compared to stocks? ›

Advantages of investing in ETFs

ETFs tend to be less volatile than individual stocks, meaning your investment won't swing in value as much. The best ETFs have low expense ratios, the fund's cost as a percentage of your investment. The best may charge only a few dollars annually for every $10,000 invested.

What are the advantages of ETFs over mutual funds? ›

ETFs and index mutual funds tend to be generally more tax efficient than actively managed funds. And, in general, ETFs tend to be more tax efficient than index mutual funds. You want niche exposure. Specific ETFs focused on particular industries or commodities can give you exposure to market niches.

What are the disadvantages of ETF? ›

Disadvantages of ETFs. Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ETFs are traded on the stock exchange like an individual stock, which means that investors may have to pay a real or virtual broker in order to facilitate the trade.

Why ETFs are better than mutual funds? ›

Less paperwork equals lower costs. Most of the time. Transparency: ETF holdings are generally disclosed on a regular and frequent basis, so investors know what they are investing in and where their money is parked. Mutual funds, by contrast, are required to disclose their holdings only quarterly, with a 30-day lag.

What are the advantages and disadvantages of exchange traded funds ETFs for trading stocks? ›

Advantages of Exchange Traded Funds
  • Advantages of Exchange Traded Funds. Diversification.
  • Liquidity.
  • Lower cost ratios.
  • Immediately reinvested dividends.
  • Lower discount or Premium in price.
  • Disadvantages of Exchange Traded Funds. Diversification is limited.
  • Intraday pricing could be excessive.
  • Dividend yields have dropped.
Apr 12, 2022

How do exchange traded funds ETFs work? ›

ETF shares trade exactly like stocks. Unlike index funds, which are priced only after market closings, ETFs are priced and traded continuously throughout the trading day. They can be bought on margin, sold short, or held for the long-term, exactly like common stock.

What is the difference between an ETF and an exchange-traded fund? ›

ETFs, the most common type of ETP, are pooled investment opportunities that typically include baskets of stocks, bonds and other assets grouped based on specified fund objectives. Unlike ETFs, ETNs don't hold assets—they're debt securities issued by a bank or other financial institution, similar to corporate bonds.

Why should we avoid ETFs? ›

Market risk

The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.

Why is ETF not a good investment? ›

Buying high and selling low

At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. Those are not good times to transact business.

Do ETFs have tax advantages? ›

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold. Internal Revenue Service.

What are the advantages of investing in an exchange traded fund ETF quizlet? ›

Exchange-traded funds can be traded during the day, just as the stocks they represent. They are most tax effective, in that they do not have as many distributions. They have much lower transaction costs. They also do not require load charges, management fees, and minimum investment amounts.

What are the advantages and disadvantages of investing in an ETF vs a mutual fund? ›

Quick Reference Comparison
ETFsMutual Funds
PricingDetermined by marketNet asset value (NAV)
Tax EfficiencyUsually tax efficient due to less turnover and fewer capital gainsNot as tax efficient due to more turnover and greater capital gains
Automatic InvestingNot availableYes, for investments and withdrawals
9 more rows

What is one advantage of an ETF compared to an actively managed fund? ›

ETFs and index mutual funds tend to be generally more tax efficient than actively managed funds. And, in general, ETFs tend to be more tax efficient than index mutual funds.

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