Although exchange traded funds (ETFs) are very attractive investment tools, they do have some limitations and aren’t always the answer to all investors’ needs.

ETFs own baskets of stocks, which enable an investor to spread risk over over many companies and investments. They also generally offer low fees and may be tax-efficient, as well.

The beauty of ETFs, especially the SPDR S&P 500 (SPY), is that one owns shares of stocks in all industries and sectors, which cuts exposure to a particular industry and the expense ratio is far less than that expenses associated with to buy shares in each of the 500 companies represented.

However, that doesn’t mean an investor should throw caution to the wind, because just as with any investment, ETFs have risks, too. Matt Krantz of USA Today warns investors of the following downsides of the versatile tool:

  • Don’t assume that ETFs automatically eliminate or lower risk. There are risks with any investment, and ETFs are no exception. Some ETFs own stocks that move in tandem. Others deliver exposure to a volatile market, such as oil.
  • Some ETFs give exposure to industries on the side – for example, if there were an automaker ETF, it may not only have GM and Ford, but also some suppliers. You wouldn’t be reducing your risk, because the fate of the suppliers is tied to the success of the auto industry.
  • Not all ETFs are created equal and some do charge high fees, which may even outstrip what equivalent mutual funds charge. Always look under the hood.

Just like any other investment option, do your homework, ask questions and know what your overall goals are before taking any positions.

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.