ETF Talk: Revealing Fund Flaws

Subscribers to my investment newsletters and trading services know about my passion for exchange-traded funds (ETFs). During the past several months, I have provided you with features aimed at helping investors improve their portfolios with a variety of funds that are both diversified and cost efficient. Time and time again, I have praised ETFs: my favorite investment tool.

Today, however, I am going to point out a few disadvantages of trading ETFs. Before I get started, if you have any questions about ETFs that you’d like me to answer in an upcoming ETF Talk feature, please click here.

I still believe that the positives far outweigh the negatives when it comes to ETFs. However, it is important for investors to understand both the pros and cons of any investment tool — especially in this ever-so-volatile market.

One of the reasons I think ETFs are a smart investment is their modest cost. ETFs offer low expense ratios, and annual expenses typically are deducted from dividends. ETFs also produce fewer capital gains and are more tax efficient than mutual funds. But investors must buy ETFs through a broker. Brokerage fees often can outweigh the low-cost tax advantages of ETFs. Therefore, ETFs probably are not for short-term investors who trade shares frequently.

In the past, I have noted that I love the simplicity and variety of ETFs. One downside of ETFs being so easy to trade, however, is that there is a risk that investors will move into sectors that they believe are hot — and then wait too long to sell. Often, individual sector funds lack the diversification to insulate you from taking a hit when that sector starts to retreat.

ETFs also can be limiting. Although the number and kinds of ETFs are growing everyday, there still are sectors or regions that have limited or no representation via ETFs.

There also is an increased volatility and market risk when trading ETFs. Many sector or single-country ETFs may be overloaded in one stock or have a large amount in its top 10 holdings. Investors also should consider the economic situation, currency risk, and political risk when investing in single-country ETFs.

Finally, ETFs still are relatively new. Investors should do their homework before investing in any ETF. Make sure your investment advisors are knowledgeable with investing in these unique funds.

After reading some of the disadvantages of trading ETFs, you might wonder why I am so enthusiastic about these funds. Despite the limitations of ETFs, I believe they are the most cost efficient and diverse investment tools now available to investors.

Remember that in volatile economic times like these, it’s important to invest with extreme caution — that holds true for any financial instrument, including ETFs.