ETFs or exchange traded funds are great investment tools for both large and small investors. Although they share some salient features with mutual funds, ETFs are traded like stocks, making them a very popular investment option today. However, before digging in, there are some downsides that prospective investors need to be aware of. After all, good information is an investor's most vital tool in making sound investment decisions. Let me cite the 5 biggest flaws of ETFs that you should not, in any way, overlook.
Perhaps the biggest advantage of ETFs is the way they are traded - like stocks. Thus, investors can buy and sell during normal trading hours and they can place advanced orders like stops and limits. In comparison, you can only make a mutual fund purchase after the closing of the market, once the fund's NAV is computed.
When trading in ETFs, you pay a commission for every buy or sell transaction you make. Your investment profitability may suffer because trading fees can quickly accumulate, depending on the frequency of your trading activity. No such fees are imposed when buying into no-load mutual funds. This should be considered when deciding between mutual funds and/or similar ETFs.
This is one of the biggest factors affecting an instrument that is publicly traded like ETFs or stocks. Depending on the size of your position relative to the average volume, you may find it difficult to get out of an ETF investment that is thinly traded. Large bid and ask spreads are a major determinant of a non-liquid investment.
Trust me when I say that it is important to see to it that a particular ETF you are eyeing is liquid, considering the numerous new ETFs coming into the market. Study the market movements and the spreads over a period of one month or one week, at the very least. Do not go for ETFs with large bid and ask price spreads.
Unlike mutual funds, ETFs can be diversified, and this is a good thing for investors. However, just because it may contain several underlying positions does not necessarily follow that an ETF is not susceptible to volatility.
Susceptibility to major swings depends primarily on the fund's scope. It is important to know the focus of the funds and the investment types that they include. Thus, an ETF that tracks a particular sector or industry such as the oil industry is likely to be more volatile than an ETF tracking a wide market index like the S&P 500. The key is in understanding the focus of the ETF and the inherent risks that come with it.
Capital Gains Distribution
There are cases when ETFs will distribute capital gains to their shareholders. However, some ETF holders do not see it as desirable, as they will be liable for the capital gains tax due. They prefer that the gains be retained and reinvested, rather than having them distributed and be burdened by the tax liability. However, in order to reinvest and buy more shares, investors will have to return to their brokers; and this results to new fees, so you have to weigh which option will be more beneficial to you.
Dollar-Cost Averaging vs. Lump Sum
Buying ETFs on a lump sum basis is easy. If you want to invest $10,000, for example, on an ETF, you can calculate the number of shares you can purchase, taking into consideration the cost of commission. The number of shares you get will be reduced based on the amount of commission you have to pay. I know some small investors who resort to another tested way to build a position; and this is called the dollar-cost averaging method.
Using dollar-cost averaging, the same $10,000 can be invested in smaller monthly increments; for example, $1,000 a month. In some months, you will get more shares for your grand when the price is lower. However, in months when the price is higher, you will be able to buy fewer shares. One big problem with this method is that since ETFs are traded similar to stocks, each $1,000 stock purchase will be charged a commission by the broker. If you ask me, and if you can afford it, always go for the lump sum approach which can be more favorable in the long run.
The growth and popularity that ETFs currently enjoy are well-deserved, in most cases, that is. However, there are the disadvantages I listed above that you have to consider in making an informed investment decision that will help you steer clear of potential pitfalls. Ultimately, your success as an investor will depend mainly on your sound judgment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.