Few things are perfect, and exchange traded funds (ETFs) are no exception. While ETFs have done much for investors of all types, along with all of their benefits come some risks that you should keep in mind, too.
ETFs come with a variety of advantages that far outweigh the risks. But an informed investor is a good investor. Not all ETFs are right for all investors, so knowing their benefits and drawbacks can help you use them more effectively.
Let’s start off with the good stuff first:
- Intraday Liquidity: ETFs trade all day on an exchange like a stock. If you want to sell it at noon, you can sell it at noon. Anytime the market is open for business, you can buy and sell ETFs.
- Transparency: You always know what’s in your ETF. There’s no waiting around for a quarterly report. Any time of day, this information is readily available on sites like Morningstar, Yahoo! Finance and the ETF provider’s website.
- Tax Efficiency: Unlike mutual funds, ETFs do not have to hold cash or buy and sell securities to pay investors when a redemption is requested. In most ETFs, shares can be created as needed, which means greater tax efficiency for you. [The Creation and Redemption Process Explained.]
- Lower Fees: An ETF’s annual expenses and trading costs are on average lower than non-index mutual funds because, as passive instruments, few ETFs have an active manager’s salary to pay. [The Cost of High Fees.]
- Access to Exotic Asset Classes: Currencies, commodities, many sectors and leverage are all available to individual investors via ETFs. Playing these areas has become much more simplified for the Average Joe, but anyone can play along. [How to Protect Yourself from the Deficit With ETFs.]
And now for some of the things you should watch out for when looking at ETFs:
- Fees: If you’re trading ETFs frequently, you run the risk of racking up broker’s fees that eat into your returns. [ETFs and Taxes.]
- They’re Not Always Cheap: As we stated above, ETFs are cheaper than mutual funds on average. Not all ETFs boast low expense ratios, so be sure to do your research before you buy to ensure you’re getting the best deal.
- Less Liquid Areas: ETFs that focus on esoteric sectors may not be as liquid as a fund that tracks the S&P 500. If you want to invest in one of these funds, be sure to use limit orders and keep your trades small in order to avoid moving the price of a low volume fund too much.
- Taxes: Some ETFs, particularly those that trade futures contracts, can trigger taxable events in the form of a K-1. Know which ETFs these are so you don’t get surprised when it’s tax time. [How Commodity ETFs Are Taxed.]
- Leveraged and Inverse ETFs: Leveraged and inverse funds are great tools…for the right investor. They’re not for everyone, and if you’re considering employing one of these funds to hedge your portfolio, understand them inside and out. [Our Guide to Leveraged and Inverse ETFs.]
For more stories about ETFs, visit our ETF 101 category.
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.