Last Updated on 20 April, 2023 by Samuelsson
Exchange Traded Funds are the latest investing trend. The popularity of Mutual Funds has been waning in the last couple of decades since ETFs are quite similar in nature, yet more liquid due to them being traded on an exchange. Many people wonder if you can trade ETFs like Stocks since they can be purchased on an exchange.
You can trade ETFs just like stocks. ETFs are very liquid and function quite the same as a stock does. ETFs have the benefit of letting investors and traders easier diversify their investment or position to reduce risk.
Let’s have a look at a few more of the benefits and disadvantages of ETFs when compared to stocks. But first, let’s begin with some quick information on what an ETF is!
What Are ETFs?
ETFs are quite similar to mutual funds in many ways. ETFs consist of a pool of various different securities such as stocks and commodities. Some ETFs track indexes while others are actively managed. On top of that, you also have a choice between ETFs that specialize in a certain class of securities and ETFs that are widely diversified in their investments.
The main area where ETFs differ from mutual funds is the fact that they are listed on a stock exchange. Mutual Funds can usually only be traded after the day’s trading has ended. This is when their Net Asset Value is calculated and people can either buy or sell them.
Since ETFs are listed on a stock exchange, they can be traded at any time as long as the market is open (unless you trade on the after-hours market). The vast majority of the popular ETFs are very liquid and you should not have any trouble selling or purchasing them as the need arises.
However, do remember that just because you can trade ETFs like stocks does not mean that they are the same thing. Let’s look at the advantages and disadvantages of trading ETFs as compared to stocks.
Advantages of ETFs Over Stocks
ETFs have been around since the 1990s, and they have become all the rage in recent years. There are a lot of reasons why people prefer to have at least a part of their portfolio in ETFs. Some of them include diversification, tax breaks, and indexing. Here is why you should buy ETFs over stocks.
ETFs Offer Cheap Diversification
If you are someone who does not possess a lot of capital, it can be difficult to diversify your portfolio across multiple industries. Each stock you purchase adds another stock for you to keep tabs on. This means that those who do not trade stocks full time will have a problem keeping up to date with their portfolio.
On top of that, buying individual stocks will require you to take up extra transaction costs. However, buying an ETF automatically offers diversification across multiple different industries. If you want to diversify even further, you can purchase ETFs of different commodities. For example, you can purchase one ETF which holds stocks and one which holds other commodities (e.g oil, gold).
Many ETFs are Indexed
Warren Buffet, the most famous of all investors, recommends Index funds over everything else for the passive investor. Index funds are great since they are automatically diversified. On top of that, they follow the universal truth: ‘stocks go up in value over time’.
Many professionals manage ETFs. However, those looking to invest in the long term without any massive risk can simply purchase an ETF that tracks a market index and forget about their investment.
Another benefit of using an indexed ETF is the fact that you can avoid paying many of the fees since there isn’t a management team required. For example, the SPDR S&P 500 Index ETF only charges a 0.09% management fee. This is one of the lowest in the industry and amplifies your profits by a significant margin.
More related reading: ETF Trading – SPY
Taxes Rates are Lower for ETFs
Without going into the complexities, the capital gains tax on ETFs is lower than that on mutual funds. Not only that, but you only pay tax on your gains from an ETF if and when you decide to sell it. As such, investing in a diversified pool of stocks through an ETF can be better for long-term investors.
On top of that, any qualified dividend paid out to you through ETFs will be taxed at a lower rate than your other income. This only further enhances the value of ETFs for passive investors.
Disadvantages of ETFs
Although ETFs have their place in your investment portfolio, they also have their negatives. Stocks are the tried and tested method of investment. As such, many people simply prefer stocks to ETFs. Here are a few reasons why ETFs may not be the investment for you.
ETFs Restrict Returns
Since ETFs are diversified across a number of stocks, this means that you cannot enjoy the large gains bought forth by a single growth stock. ETFs are bound to grow at a much slower rate than good growth stocks. Indexed ETFs are especially prone to this fallacy since indexes grow at a stable but somewhat slow rate.
Those who have a higher appetite for risk might be able to magnify their returns many folds in a single year by researching growth stocks and investing in them.
ETFs May Have Improper Diversification
Many ETFs may be perfectly diversified across various different industries. Still, it is possible that they could be prone to various different market risks. For example, stock-based ETFs might be diversified, but they would still be liable to the entire market going down. An even more extreme example would be an ETF investing in oil companies losing value due to a decline in oil prices.
A good way to combat this is by diversifying your ETFs selection across multiple sectors and industries. This is another way in which ETFs are similar to stocks. You can purchase as little or as much of an ETF as you want, and it is possible to diversify your portfolio across multiple different industries by purchasing a few ETFs as opposed to a lot of stocks.
Taxable Income Control
Although ETFs are generally beneficial as far as taxation is concerned, this is one area where they are simply not up to the mark. Towards the end of the tax season, one of the best ways to decrease your tax liability is by selling stocks that have lost value over the course of the last year. This way, the loss that you incur decreases your capital gains.
A decrease in capital gains also decreases the total amount of tax that you have to pay. While it is possible to reduce your taxable income this way through individual stocks, you cannot do so with ETFs unless you decide to sell the entire ETF.
Technically, it is possible for you to trade ETFs like stocks. ETFs are available on the stock exchanges and you can purchase or sell them at the market rate just like a stock.
However, do remember that for people who don’t trade, ETFs work best when held for the long-term, just like a mutual fund. ETFs, for the most part, are more liquid than mutual funds and can be sold during trading hours in the event of a change of plans. Still, there are some ETFs that are illiquid and may need more time to be sold.
It is best to think of ETFs as you would of any other fund and properly research them before you invest. If you are a passive investor, you might want to consider indexed ETFs over managed ETFs as they would require the least amount of research and are the perfect investment for long-term portfolios (e.g. for your retirement).