Although exchange-traded funds have several advantages over mutual fund products, they also come with their fair share of potential problems. Some parts of the ETF industry are improving already. Still, today we’ll take a look at 12 specific ETF flaws that investors should be aware of to improve their investing results and protect themselves from unnecessary risks.
There’s no such thing as a free lunch, especially when it comes to investing your money. When you purchase shares in an ETF, somebody must pay for the underlying expenses necessary to make the product work.
If you own an ETF, it’s essential to understand exactly what the fund is designed to do and how well or poorly it has been executing its given strategy. In many cases, index-based ETFs have an excellent track record of mirroring their underlying indices closely, but tracking errors can get pretty extreme in some instances.
Unique Tax Characteristics
One of the best things about owning stock through a traditional brokerage account is that your long term capital gains are taxed at a preferential rate relative to other investment income such as interest from bonds or dividends from companies. However, if you hold shares in an ETF for more than a year, those long term capital gains may be taxed at the same rate as ordinary income.
Another critical thing for investors to be aware of is the liquidity of the ETF products they’re considering. In general, the more popular (and therefore liquid) an ETF is, the better, but even among the most popular funds, there can be significant differences in how easy it is to buy and sell shares.
While we’re on the subject of ETF tracking errors, it’s essential to understand the difference between total tracking error and incremental tracking error. Cumulative errors occur when an ETF fails to match its benchmark index by small amounts over short periods (days, weeks), and they can be pretty standard.
With traditional stocks and bonds, investors typically don’t have to worry about whether or not there is enough capital available to cover their positions in the event of a market crash. However, this is not always the case with ETFs, which can sometimes be quite thinly traded.
Lack of Diversification
While all ETFs offer some degree of diversification, it’s important to remember that they are not created equal. Depending on the underlying holdings, an ETF can be much more or less diversified than another product with a similar name.
Single Asset Classes
Along the same lines as the lack of diversification, investors should be aware that many ETFs focus on a single asset class.
Lack of Transparency
Not all ETF sponsors are created equal when providing information about their products. In some cases, investors are given very little detail about the underlying holdings and strategies used by an ETF.
The more complex an ETF is, the more difficult it can be to understand how it works or exactly what types of securities are being held. Even some trendy products have complicated structures that investors may not fully grasp before buying.
One last thing investors should realize about ETFs is that they are sometimes used as tools for taking on leverage to boost returns. Although this strategy can work well, several inherent risks are involved with these funds.
When investing in most ETFs, it’s important to remember that stocks are inherently volatile. Even the very best designed funds cannot altogether remove this risk. Therefore, investors should keep a close eye on their holdings during times of market turbulence.