Exchange traded funds were created to be user-friendly investment tools that provided instant diversification, with liquidity and transparency built in. However, ETFs do come with inherent risks and drawbacks that investors need to know about in order to avoid them

“Today, there are literally hundreds of ETFs traded regularly on major exchanges, and represent not only stock indexes, but a variety of other industries and business sectors. There are both positive and negative aspects of ETFs, and a smart investor should consider both elements before investing,” Marc Davis for Investopedia wrote. [Checkpoints on How to Really Understand ETFs]

An ETF was intended to be a simple trading tool, a basket of stocks that traded with the ease of a single stock. There are certainly lots of pros that come with ETF trading, but there are a number of drawbacks that can lead to unanticipated losses. Here are a few points of caution from Paul Katzeff of Investor’s Business Daily:

  • Leverage: This investing strategy was intended for seasoned traders and professional investors, not the individual retail investor that has a buy-and-hold strategy. A leveraged fund is intended to be monitored daily since they double or triple the index gains – and losses. A leveraged ETF is used for hedging and short-term trading and should not be used to short or magnify an index that is going up or down. This can backfire with large losses. [Total Stock Market ETFs]
  • Diversity: This is a key selling point of an ETF. Since the funds are essentially baskets of stocks that represent an asset class or sector, the diversification benefits are great. However, the overall proliferation of the ETF business has led to plenty of ETFs created that represent small niches, odd strategies and areas that an individual investor does not need. Plus, many ETFs can be tied to unknown or untested indices, with limited liquidity, which can cause an investor to take losses if they wanted to sell the fund. This can lead to confusion and an overload of choices to research.
  • Fees: ETFs were initially touted for the low costs factor, but traders have found that excessive activity leads to brokerage fees that can add up. A few too many fees can be a weight on performance and may even eat into the initial capital.U.S. stock ETFs’ average audited annual expense ratio of 0.51% is less than half the 1.37% expense ratio of U.S. stock mutual funds. There are exceptions, however, and these can be found in actively managed ETFs, niche ETFs, and those funds that re-balance regularly. [What is an ETF? – Part 23: Backwardation and Contango]
  • Contango: This is a huge problem for investors that buy commodity ETFs. An ETF that invests in futures contracts versus the actual physical material, such as United States Oil (NYSEArca: USO), will present the situation. When a near-term contract is about to expire, the ETF sells it, using the proceeds to buy another contract, which because of contango is more expensive. As a result, a contango environment can cause ETFs holding futures to lag their benchmark index. An ETF that invests in a physical commodity avoids the chance of locking you into a series of more expensive contracts. [Commodity ETFs to Fight Inflation]

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.