The rapid expansion of the exchange traded fund industry is testimony to its popularity. The tools have become a popular option for investors searching for low-cost diversification. But these funds are not without points of caution that investors should be aware of.
There are around 1,400 ETFs to choose from, so at a glance the choices can be intimidating. Here are a few drawbacks to keep in mind:
- Bid/Ask Spreads: Be aware of the bid/ask spread, because this is a good indicator of the liquidity of the fund. A high bid/ask spread is a red flag, as it indicates low trading volume and the possibility of overpaying for a fund. [How Premiums and Discounts are Caused]
- Emotional Reactions: A trigger event such as a sell-off of Apple (NasdaqGS: AAPL) stock could create the sale of ETFs holding the shares. This will create higher volatility in the market and in turn, does not mean it is time to sell, reports NewsCore on Fox Business. Be aware of the companies a fund holds and if one company is creating negative sentiment, know that this is why a diversified fund can mitigate risk.
A few high points of ETFs:
- Low-Cost: David Twibell, the president of Englewood, Colo.-based Custom Portfolio Group LLC, says that ETFs have low annual expenses, especially in relation to mutual fund charges. Since most ETFs are passively managed, there are less fees to pay. On average, a typical ETF cost is less than two tenths of 1%, or 20 basis points per year, compared to more than 1% annually for mutual funds, according to Nasdaq.
- Flexibility: The ability to trade throughout the day like a single stock and the transparency of an ETF is a huge plus. At any time of day, an investor can find out what the fund is invested in and can buy or sell one. This feature is a plus for risk management. [ETF Providers Call For More Product Transparency]
- Tax Efficiency: The basic concept of capital gains puts ETF investors at an advantage. If an investor sells shares of an ETF, only they are hit with the taxes. Other shareholders are left out of the equation.If a mutual fund investor sells shares, all shareholders are hit with the capital gains, which can be a huge disadvantage. [ETF Tips as the Tax Deadline Looms]
Of course, the highs and lows of ETF investing are numerous, so it is important that investors so some research before they buy. Also, it is wise to have a solid strategy in place, with clear entry and exit strategies. This can help avoid emotional decisions.
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.