ETFs are growing in popularity due to their low costs, broad diversification, and ability to be traded like stocks. ETFs track indexes like mutual funds but trade continuously throughout the day instead of just at the end of the day. The pros of ETFs include tax efficiency, lower fees, flexible trading, and a wide variety of asset classes. However, the cons include occasional unwanted distributions, brokerage fees, bid-ask spread issues, liquidity concerns for less traded ETFs, and potential tracking error versus the underlying indexes.

1. The Pros and Cons of ETFs<br />If you don’t know what an exchange –traded fund is, then you need to pay attention. ETFs are growing in popularity with both institutional investors and retail investors. There’s good reason for that : ETFs offer low costs and broad diversification. Think of them as index funds on sale; their expense ratio are minuscule. But before you jump in, it pays to understand these hybrid vehicles. In general, an ETF mimics an index fund in composition.<br />However, ETFs differ from traditional open-end mutual funds in the manner in which they are traded: ETFs trade like individual stocks. You can purchase them in real time at any point during the day, unlike mutual funds, which settle only at the day’s close. You can use trading features like stop losses on an ETF; you can’t on an open-end mutual fund. And there are no redemption fees on ETFs unlike on many of their mutual fund cousins.<br />The Pros..<br />Tax efficiency: <br />When a mutual fund is faced with shareholder redemptions, it must sell underlying securities to raise the cash to pay shareholders. Any capital gains that are triggered by those transactions are passed on to the remaining shareholders. Because shareholders sell shares to others, ETFs don’t have to sell underlying securities to meet redemptions. As their underlying benchmarks change, of course, ETFs may have to periodically pay out distributions. In general, though, distributions should happen less often with ETFs than with traditional mutual funds.<br />Cost efficiency: <br />Annual fees are often lower than they are for comparable mutual funds<br />Flexible trading: <br />You can trade at any time of the day. And unlike some tax-managed funds, you won’t have to pay any back-end fees or penalties when you redeem.<br />Various prices throughout the day : <br />ETFs allow you to purchase shares at varying prices throughout the day, which could be an advantage in the implementation of your investment strategy.<br />No minimum investment : <br />You just have to have enough money to cover the cost of buying a single share, plus the broker’s commission<br />Wide variety of asset classes and a true global product: <br />ETFs can be bought and sold in any country in the world with a broad scope of investment options.<br />Style consistency: <br />If you have structured your portfolio to allocate a certain percentage of assets to various styles and/or sectors of the market, you want your investment vehicles to remain “true” to their stated objective. By using ETFs that track a particular underlying market segment either with a leveraged short or long view, you may be able to execute your strategy more effectively than if you rely on actively managed mutual funds.<br />…and Cons<br />Occasional unwanted distributions:<br />Much to the disappointment of individual investors, some ETFs have distributed capital gains.<br />Brokerage Fees:<br />Every time you buy or sell an ETF, you pay a brokerage commission. For some investors, these fees can offset the lower annual costs that ETFs usually charge. Keep in mind that if your custodian offers free trades, this disadvantage disappears.<br />Bid/ask spread issues:<br />Because of the way ETFs are structured, you could end up buying an ETF at a premium to the portfolio’s value and selling at a discount. Although this is uncommon, it can happen-particularly in thinly traded markets. And the more volatile the market is, the wider bid/ask spreads may become.<br />Liquidity, low trading volumes, settlement concerns:<br />In less-efficient markets, it may take time to match an ETF seller with a buyer.<br />UIT format:<br />Some of the older ETFs are structured as unit investment trusts, and, because of that, they may have a “dividend cash drag.” In UITs, dividends will be held in an interest-bearing account until the end of each quarter before reinvesting them in the account. In contrast, a mutual fund is able to reinvest dividends daily. The delay in reinvesting dividends in UITs can have a negative effect on total returns.<br />May not replicate returns of underlying portfolio:<br />Tracking error, management expenses, and the liquidity of the market the ETF targets can lead to returns that don’t match those of the market. This can also be a problem with mutual funds, but it seems that the effect can be more pronounced in ETF products.<br />