Exchange traded funds (ETFs) benefits’ include high liquidity, transparency and intraday trading. However, these advantages can be disadvantages at times. For example, the convenience of intraday trading that stocks and ETFs share costs investors commission fees. Depending on how often investors trade, fees can accumulate, thus reducing their investment’s performance, says John Devcic for Forbes.
Another potential drawback is underlying fluctuations. Diversification is a great trademark of ETFs, but that doesn’t offer complete protection from volatility. Granted, the more diversified an ETF portfolio the less volatility will affect it. This highlights why its vital for investors to know what’s in their ETFs. Liquidity is another benefit that can be a problem when ETFs are thinly traded. If there’s a large gap between the bid and ask price, it could be a sign that its an illiquid ETF. Looking at the assets under management for a particular ETF can also give investors an idea of its liquidity: If it’s high, it’s probably OK.
More often than not, ETFs do not distribute capital gains; however, they can and there are a few that do, which means shareholders are responsible for paying the capital gains tax. Finally, another snafu that investors can run into with ETFs is whether to use a cost averaging strategy or a lump sum. If investors use the dollar-cost averaging strategy, (which is investing a little bit each week, month, year, etc.), it can become costly because investors will have to pay commissions every time.
These are all issues to keep in mind, but the benefits of ETFs still outweigh their disadvantages.
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.