There are a number of reasons why an ETF (exchange traded fund) can be a safer and more cost-effective investment than a mutual fund or a portfolio of individual stocks.
ETFs are a quick and easy way of creating a diverse portfolio. Investments in ETFs can cover a wide range of options in a number of sectors, locations and classes of assets, as well as different investment strategies. They usually track a collection of securities that underlie the benchmark index. This benchmark can be formed from bonds and stocks, as well as other securities (e.g. commodities). It is much harder to create such a diverse range of investments by investing in each element individually and the risks are much less with ETFs. One or two ETFs can provide as much asset class coverage and weighting as a large selection of carefully researched stocks and bonds.
There is excellent trading flexibility with an ETF. Unlike mutual funds, where the sale is processed at the end of day net asset value prices, ETF sales go through immediately. ETFs trade globally on all the main stock exchanges so the price you get will be the price quoted at the moment of sale. A range of choices for trading is available, including limit and market orders, buying on a margin, and short selling. It is sometimes possible to buy and sell options on ETFs on derivative markets. There is no minimum investment threshold required to buy ETFs.
It has been proven in numerous studies that mutual funds rarely outperform the return of an index. ETFs can do much better than mutual funds. They can efficiently realize index performance and the yearly management fee is lower than for mutual funds.
This cheaper management fee means that investing in an ETF can be more cost effective than putting your money in a mutual fund. Over a long-term investment, this difference can add up to substantial savings.
Plenty of information is available for investors to see what is happening to their ETF investment. The holdings are reported on a daily basis, with the specific weighting of the constituents of the tracked index being disclosed. This will show when there has been a modification of the position of the ETF in a particular security. The transparency this gives generates confidence in the maintenance of the original strategy.
Mutual funds generally limit their reporting to just twice yearly, which can leave the investor unaware of what is going on for many months at a time. By the time the report is made available, the fund could have changed drastically in terms of the holdings, weightings or investment style.
It is usually more tax efficient to invest in an ETF rather than a mutual fund. Capital gains tax is usually only paid on ETF investments when shares are sold, while it must be paid on the gains made by a mutual fund even while the funds are being kept in it. The investor could also end up paying more capital gains tax if they invest in individual shares and stocks, as there will be frequent tax payments to be made and there will also be transaction commissions to pay. ETFs may offer regular dividends or distributions and tax will have to be paid on these if it is held in a non-registered account.
The diversity of ETF investments means that they can be far less volatile than other investments, which reflect the daily changes of individual stocks. The overall ETF movement will depend on all of the holdings that are part of the fund, so the other holdings will moderate a single volatile movement in one. This reduces the risk to the investor.