4 Flaws to Consider Before Investing in ETFs

By InvestingAnswers Staff

ETFs are extremely useful tools that allow investors to achieve portfolio goals that have long been the exclusive province of professional big-money managers. No longer.  ETFs can give individual investors easy access to commodities and foreign markets. They are also well suited to track specific sectors.  Short and ultrashort funds allow investors to take either side of the trade and use leverage to bolster their return potential. And all of this is possible from your existing brokerage account.

For all their pluses, however, ETFs are not perfect and in some cases may have more potential for harm than for good. Here are four ETF flaws you should bear in mind before investing.

Management fees

ETFs and mutual funds share a number of traits, and one of them is that both charge fees. ETFs, because they are usually passively managed, typically have very low expense rations. But typically is not always, and some ETFs charge levy substantial charges.

While the vast majority of ETFs have fees below 0.75%, fees in excess of 1% are becoming more common as this asset class continues to develop. Fees come out of gains in good years and add to losses in bad years. It is vital for investors to know up front what they will be paying. For passively managed funds, shopping on price is a worthwhile endeavor.

Trading expenses

Management fees are something mutual funds and ETFs share. But mutual funds, in most cases, do not subject investors to trading fees. While some mutual funds charge an early redemption fee and many funds carry a front-end or back end load, many funds can be easily bought and sold at no cost.

That is not true with ETFs. You'll pay a commission on the trade when you buy and a commission on the trade when you sell.

The ramification of this fact is that ETFs can be unsuitable for small investors. Buying $100 worth of an ETF at discount broker will cost $7, or 7%. A few mutual funds -- those with 5.75% front-end loads and 1.25% in fees, will incur these level of expense.

And if the investor decided to exit the trade, it would cost another $7 to do so. That's 14% of the initial $100 invested -- and that's pretax, which would eat a quarter of any gain. It would also take an exceptional return to make that level of expense cost effective. No-load mutual funds are likely a far better option for small investors. 

Cyclical

All mutual funds share a common strategy: Each seeks to generate returns regardless of the market. A growth-oriented fund isn't supposed to track the market but to exceed its gains. Most mutual funds investors, thus, employ a long-term buy-and-hold strategy.

This is totally unsuitable for most ETFs.

Why? Because ETFs are not designed to beat the market. They are passive tools for active investors -- you buy an ETF that's long oil when you think oil is going to rise; you buy a short ETF when you think oil is going to fall. Neither of these ETFs, however, would be appropriate for a long-term investor, as the price of a commodity is too volatile.

Mutual funds are good long-term investments: A few good ones you can buy and forget; they'll perform well over the years. But ETFs -- with the exception of a few income-related choices -- are tools to use to time market cycles, to buy low and sell high in the relatively short term.
 
Nondiversified

An S&P 500 fund spreads your assets over 500 companies. Your investment will move with the market. When you hear on the news that the S&P was up 1.2%, you know that your investment did the same thing. But though ETFs were originally designed to mirror broad-market indexes like the Dow and the S&P, many ETFs now track far narrower indexes and have only a few dozen closely related companies in their portfolios.

This lack of diversification can be a great thing: If you own pharmaceuticals while drug makers are having a great year, you're going to beat the market.

But if it’s a bad year for companies like Pfizer and Merck, then your investment is going to lag the S&P.

It's crucial that investors know what they are buying, and why. They must understand the risk and the potential reward and be comfortable with each.

If you're willing to shoulder the risk of buying a specific sector, then ETFs can be just what the doctor ordered.

The Investing Answer: If you would feel safer with a more diversified strategy, then either stick with a Spider or Diamond ETF or go with an actively managed and appropriately diversified mutual fund.

Exchange traded funds are a recent innovation on Wall Street that has revolutionized the choices available to individual investors. They aren't perfect, nor are they the worst opportunity. ETFs have many advantages, but, like all investments, you should only use ETFs after carefully considering your investment objectives, available capital, time frame and risk tolerance.