There are a lot of good reasons to invest using exchange-traded funds. The fund industry has developed ETFs to cover a very wide range of investment choices, making it easy to invest in some asset classes that were formerly out of the reach of individual investors. However, before jumping into the ETF pool, an investor should be aware of some of the drawbacks of ETF investing. ETFs compete with index mutual funds, which may have an advantage in certain circumstances.
Compared to no-load index mutual funds, the costs to invest in ETFs are higher. Since the shares trade on the stock exchanges, each time ETF shares are bought or sold, a broker's commission must be paid. Exchange-traded securities, including ETFs, also have bid/ask spreads where shares are purchased at the ask price and sold at the bid price. This spread can add a few cents per share to the transaction costs of investing in ETFs. If you want to reinvest ETF dividends, you must pay commissions again to buy the additional shares.
Temptation to Trade
Since ETF shares trade on the stock exchanges, it is easy to trade in and out of these funds. Online discount brokerage accounts allow investors to buy and sell with a couple clicks of the mouse. As a result, investors who may be better off following a long-term investment strategy could get sucked in to short-term trading, trying to catch the hot ETF of the day, week or month. An ETF investor must decide whether he is a long-term investor or short-term trader and use appropriate strategies for the selected type of ETF investing.
Use of Derivatives
ETFs which track the value of commodities often use futures or other derivative contracts to provide the value backing the ETF shares. For example an ETF that tracks the price of oil does so by buying and selling oil futures. It is possible in a time of severe financial disruptions that these derivative contracts may not produce the expected values or even result in significant losses to ETF investors. If you plan to invest in a commodity fund, find out what types of securities the fund uses.
The companies that develop ETFs have produced funds to cover a lot of different possible market results. Leveraged and inverse ETFs provide results that are a multiple of the designated index or change value in the opposite direction. For example, an inverse S&P 500 will go up in value if the S&P 500 stock index goes down. A leveraged S&P 500 ETF will change value at 2 or 3 times the change in the stock index. The Financial Industry Regulatory Authority warns that these types of funds have extra risks and are not suitable as longer term investments.