Learn the ABCs of ETFs

Demerits and Disadvantages

Nevertheless, there are potential disadvantages in using ETFs compared with mutual funds, most notably the brokerage costs associated with purchasing and selling them, and the intrinsic inability of ETFs to beat their benchmark index.

Though investors enjoy lower expense ratios, they must still pay a brokerage commission to purchase and sell shares for all index ETFs. This can significantly increase the cost of investing for those who trade frequently or who practice dollar-cost averaging with their purchases. So while index ETFs may have lower expense ratios, the total cost to the investor may not be lower.

The goal of many investors is to beat a benchmark index such as the S&P 500 or the Dow Jones Industrial Average. They do this by investing in actively managed mutual funds. The goal of ETFs, however, is to track the benchmark index as closely as possible, thereby forgoing the opportunity to outperform it.

(The ideal solution for investors looking to beat their chosen benchmarks would be actively managed ETFs. Because of structural difficulties, however, actively managed ETFs have yet to be introduced into the market. So for now, passively managed index ETFs will have to do.)

The Bottom Line

ETF investors need not fret too much about missing out when it comes to performance. According to the fund-tracking firm Morningstar, only 28% of active fund managers beat the S&P 500 over the last 10 years, and only 31% trumped the market over the last 15 years.

That performance attribute, combined with the cost and liquidity benefits, makes a compelling case for ETFs.