ETFs can be an excellent investment tool for both small and large investors. These popular funds, which are comparable to mutual funds but move like stocks, have become a popular choice for investors seeking to diversify their portfolios without increasing the amount of time and effort required to manage and allocate their investments.
TABLE OF CONTENTS
Underlying Fluctuations & Risks Trading Fees
Insufficiency of Liquidity
Distributions of Capital Gains
How to Invest in Exchange-Traded Funds (ETFs)
Leveraged ETFs ETFs vs. Exchange-Traded Notes (ETNs)
Loss of Taxable Income Issues with Control ETF Performance Expectations
However, investors should be aware of a few pitfalls before diving into the world of ETFs.
ETFs have grown in popularity among both active and passive investors.
While ETFs offer low-cost exposure to a diverse range of asset classes, industrial sectors, and overseas markets, they do introduce certain new risks.
Understanding the nuances of ETF investing is critical so that you are not caught off guard in the event of a market correction.
5 ETF Weaknesses You Should Not Ignore
Fees for Trading
One of the primary benefits of ETFs is that they trade similarly to equities. An ETF invests in a diversified portfolio of companies that are often related to a common sector or theme. Investors just purchase the ETF to benefit from the efficiencies associated with investing in a larger portfolio all at once.
Due to the stock-like characteristics of ETFs, investors can buy and sell during market hours and place advanced orders such as limits and stops on purchases. In contrast, a normal mutual fund purchase occurs after the market closes, when the fund's net asset value is calculated.
Each time you purchase or sell a stock, you are charged a commission. This is also true when purchasing and selling ETFs. Depending on how frequently you trade an ETF, trading fees can quickly accumulate and affect the performance of your investment. On the other hand, no-load mutual funds are sold without a commission or sales charge, making them more favorable in this regard than ETFs. When comparing an ETF investment to mutual fund investment, it is critical to consider trading expenses.
If you're picking between similar ETFs and mutual funds, keep in mind that each has a unique fee structure, including trading expenses. Additionally, like with stocks, regularly trading ETFs can significantly diminish your investment performance as commissions quickly accumulate.
The specifics of ETF trading costs are very dependent on the funds themselves and their suppliers. The majority of ETFs charge less than $10 per order. In many situations, providers such as Vanguard and Schwab charge no fees for buying and selling ETFs. 12 As ETFs' popularity has grown, so has the appeal of commission-free funds.
Additionally, investors should be wary of an ETF's expense ratio. The expense ratio is a ratio that indicates what percentage of a fund's total assets must be used to cover annual operational expenses. While this is not identical to the fee paid by an investor to the fund, the effect is similar: the higher the cost ratio, the lower the total returns for investors. ETFs are well-known for having extremely low expense ratios in comparison to a wide variety of other investment vehicles. This is obviously something to keep in mind for investors evaluating several ETFs.
Fluctuations and Risks in the Fundamentals
Like mutual funds, ETFs are frequently praised for the diversification they provide investors. However, it is critical to remember that just because an ETF has multiple underlying positions does not imply it is immune to volatility. The possibility of significant fluctuations is mostly dependent on the fund's scope. An ETF tracking a broad market index, such as the S&P 500, is likely to be less volatile than one tracking a single industry or sector, such as an oil services ETF.
As a result, it is critical to understand the fund's objective and the types of investments it comprises. As ETFs' specificity has increased in tandem with the industry's consolidation and popularisation, this has become an even greater worry.
In the case of international or global ETFs, the fundamentals of the country that the ETF tracks are critical, as is the currency's creditworthiness. Economic and social instability will also have a significant impact on the performance of any ETF investing in a specific country or region. These variables must be considered while determining the viability of an ETF.
The rule here is to understand what the ETF is tracking and the related dangers. Do not be fooled into believing that just because some ETFs have minimal volatility, they are all the same.
Insufficiency of Liquidity
Liquidity is the most important feature in an ETF, stock, or anything else that is publicly traded. Liquidity implies that when you purchase anything, there is sufficient trading interest that you can exit reasonably fast without affecting the price.
If an ETF is thinly traded, exiting the investment may be difficult, depending on the size of your stake in comparison to the usual trading volume. The most obvious indicator of an illiquid investment is a wide spread between the bid and ask prices. Before purchasing an ETF, you should ensure that it is liquid, and the simplest method to do so is to examine the spreads and market movements over a week or month.
The rule is to ensure that the ETF in which you are interested does not have significant spreads between its bid and ask prices.
Distributions of Capital Gains
An ETF may pay out capital gains to shareholders in some instances. This is not necessarily advantageous for ETF investors, as shareholders are responsible for capital gains taxes. Generally, it is preferable if the fund maintains and invests capital gains rather than distributing them and causing a tax burden for the investor. Investors would typically wish to reinvest their capital gains distributions, which requires them to return to their brokers and purchase further shares, incurring additional expenses.
Because different ETFs treat capital gains distributions differently, it can be difficult for investors to keep track of the funds in which they invest. Additionally, an investor must understand how an ETF treats capital gains distributions before investing in the fund.
How to Invest in Exchange-Traded Funds
Purchasing an ETF with a lump payment is straightforward. Assume you want to invest $10,000 in a particular ETF. You determine the number of shares you can purchase and the commission cost, and you receive a specific number of shares for your money.
However, there is also the tried-and-true method of building a position used by modest investors: dollar-cost averaging. With this strategy, you invest the same $10,000 in $1,000 monthly increments. It's termed dollar-cost averaging since you'll purchase fewer shares with that $1,000 in some months due to the increased price. In other months, share prices will be lower, allowing you to purchase more shares.
Of course, the major disadvantage of this technique is that ETFs are traded like stocks; as a result, each time you want to purchase $1,000 worth of an ETF, you must pay a fee to your broker. As a result, monthly investments in an ETF can grow more expensive. As a result, trading an ETF favors the lump-sum strategy.
The rule is to invest in a lump sum at a time to avoid paying brokerage costs.
ETFs with leverage
When it comes to risk, many investors choose ETFs because they believe they are less dangerous than other investment vehicles. We've already discussed volatility, but it's critical to remember that certain classes of ETFs are inherently riskier investments than others.
Leveraged exchange-traded funds are an excellent example. These ETFs typically lose value over time and as a result of daily resets. This can occur even when the underlying index is performing well. Numerous analysts advise investors to avoid leveraged ETFs entirely. Investors who choose this route should monitor their investments carefully and be cognizant of the risks.
ETFs vs. Exchange-Traded Notes
Due to their similar appearance on the page, ETFs and exchange-traded notes (ETNs) are frequently mistaken. Investors should keep in mind, however, that they are two quite distinct investment vehicles. ETNs will have a declared strategy: in addition to tracking an underlying index of commodities or stocks, they will include an expense ratio.
Nonetheless, ETNs typically have a distinct set of risks compared to ETFs. ETNs are subject to the issuer's solvency risk. Investors are frequently out of luck if the issuing bank for an ETN declares bankruptcy. This is a distinct risk from the one connected with ETFs, and one that investors anxious to join on the ETF bandwagon may be unaware of.
Consequences of the Loss of Taxable Income Control
An investor who purchases shares in a pool of several individual stocks has more options than an investor who purchases the same group of stocks through an ETF. This disadvantages the ETF investor in several ways, one of which being his or her capacity to handle tax-loss harvesting. If a stock's price falls, an investor can sell shares at a loss, so decreasing total capital gains and taxable income to a certain amount. Investors who hold the same stock via an ETF do not have this luxury; the ETF selects when to alter its portfolio, and the investor must buy or sell an entire lot of equities rather than individual names.
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