How to Get Over ETF Pitfalls
May 4th 2009 at 6:00am by Tom Lydon
Exchange traded funds (ETFs) are a great versatile tool for all types of investors and offer many advantages that no other investment tool does, but there are things to be mindful of.
Those who advocate the use of ETFs note that they offer low expense ratios, diversification, tax efficiency, exposure to sectors and markets that traditionally can’t be accessed through an index and transparency. One of the greatest things they offer investors is a vast array of choices that can satisfy any appetite.
But just as with any investment, they’re not perfect and come with issues of their own. Not all of the criticism is on target, though.
David Randall of Forbes states that U.S. Oil Fund (USO) is an example of an ETF with big pitfalls. He states that this particular ETF is a disaster because it buys futures in a bid to track a thin underlying market and deceives investors.
We believe that it is a great way to grab exposure to the volatile commodity market, especially with an expense ratio of 0.45%, and utilize it as a hedge against rising oil prices. Additionally, we believe that all investors should do their homework, look under the hood, and have a strategy before entering or exiting a trade. After all, you control the destiny of your money, and you don’t have to buy a fund that doesn’t meet your objectives. Not all funds are right for all investors.
We also have a strategy when it comes to investing, utilizing moving averages, exit strategies and strategies indicating when to move back into markets. Strategies can help minimize your risk by giving you a signal to buy, as well as a signal to sell.
Another pitfall that is cited is the tax-efficiency of certain ETFs. Some ETFs are taxed and treated as shares of a limited partnership where one is taxed on a fund’s internal trading activities. Th IRS taxes these funds on the basis that 60% of the activity is long-term and 40% is short-term. As for some commodity ETFs, they are structured as grantor trusts; when shares are sold they are taxed at ordinary income tax rates. The last tax pitfall can be see in leveraged ETFs, which are taxed at short-term capital gains rates regardless of how long they are held. Keep in mind that these pitfalls arise only in a few types of ETFs, as for all the others, they still remain efficient and don’t shoot off the capital gains that their mutual fund counterparts do.
The last pitfall that opponents cite is the riskiness and exposure offered by leveraged ETFs. These ETFs are structured in such a way to give double or even triple the exposure to certain markets in either the same direction or the opposite direction. Before investing in leveraged funds, you should be sure to be fully educated on how they work and their applications. These funds can be beneficial for the right kind of investor.
When it comes to investing, education is your best defense for avoiding the pitfalls of ETFs. We certainly agree that if the necessary research isn’t done beforehand, you can get burned.
Kevin Grewal contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.