Exchange traded funds (ETFs) have their rabid fans and their rabid critics. ETFs are one of the most innovative financial instruments to emerge in the last couple decades, but there are some things to look out for.
Investors love ETFs, and proof of this can be found in the fact that net inflows totaled $89 billion in the first 10 months of the year and assets both globally and domestically are at all-time highs for the industry. [ETF Invesitng and the Art of Patience.]
Andrew Barry for Barron’s reports that the ability to gain exposure to every market and asset class has made ETFs an investor favorite, and the other benefits are apparent:
- The benefits of ETFs include low fees, relative to mutual funds, transparency of investments and tax efficiency because of low portfolio turnover.
- ETFs provide exposure to specific indexes, such as the S&P 500 or the Russell 2000, as well as such investments as gold, natural gas, junk bonds, inflation-protected Treasuries and master limited partnerships. Investors truly have more choices than ever. [How to Evaluate Your ETF Choices.]
- Anyone can use them. Active traders are heavily involved with ETFs. Many day traders now play ETFs, including volatile ones that move by double and triple the daily change in their underlying indexes. But ETFs are also used by retail investors, institutions and buy-and-holders.
The industry readily acknowledges the need for more education about how ETFs work, particularly on these fronts:
- The most controversial ETFs are those designed to move two and three times the daily change in their underlying indexes by using leverage or financial derivatives. These funds have been criticized because over long periods, they often don’t track the underlying indexes, particularly in volatile markets. That isn’t because of an inherent flaw, but because of the effects of compounding often large daily movements. To learn all about leveraged and inverse ETFs, we suggest you read our special report on them.
- Commodity ETFs that use futures can be hurt by contango, a term that simply means that future prices are higher than current or spot prices. Contango forces an ETF to roll its spot contracts into higher-priced futures. Read this article to understand contango, how it works and how various ETFs work to mitigate its effects.
- Taxes are often a consideration with various ETFs; commodity ETFs are taxed differently, depending on what they own. There are taxes on dividends, and there are capital gains to think about, too. Before you buy an ETF, be sure you understand what it means for your tax picture to avoid any surprises.
Tisha Guerrero 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.