Exchange Traded Fund Disadvantages

ENTRANCE TO WALL STREET SUBWAY STATION

ENTRANCE TO WALL STREET SUBWAY STATION

Exchange-traded funds are more flexible than mutual funds, but this flexibility comes at a price. One should never assume that ETFs are a "better" investment than mutual funds by nature; there are times when investing in mutual funds may be the smarter choice. This is especially true for inexperienced investors.

Here are some of the downsides associated with ETFs.

Commissions
ETFs trade on exchanges, and -as with stocks- an investor must pay his broker a commission if he wants to trade on an exchange. So, although an index mutual fund may have a higher expense ratio than an ETF, an investor does not have to pay a commission to buy a dollar amount of a mutual fund or to redeem his mutual fund shares. A short-term investor looking to trade ETFs frequently (as opposed to an investor who employs the buy-and-hold strategy) will see brokerage commissions eat away at his profits.

For more information on commissions and how they work, visit the "Commissions" section under Online Brokers. 

Trading
It is important to remember that some ETFs are less liquid than others. The bid/ask spread on illiquid ETFs can be very wide, and this can amount to a significant additional cost to the investor (for more information on the spreads, visit The Bid/Ask Spread in our Stocks section).

The liquidity of an ETF is largely determined by the liquidity of its underlying securities. ETFs that track U.S. equities are the most liquid ETFs. Furthermore, equity ETFs that track major broad-based U.S. indexes are more liquid than equity ETFs that track stocks from small or mid-cap U.S. companies. For example, the S&P 500 ETF is by far the most liquid ETF available, and it trades at the smallest possible spread (a penny). Finally, keep in mind that liquidity is lower for ETFs that target specific sectors as opposed to ones that track broad indexes.

ETFs that track other asset classes- such as currency or real estate- are much less liquid and trade at wider spreads. So, although ETFs allow an investor to target specific sectors and asset classes, TeenVestors are encouraged avoid to focus on broad based equity ETFs.

Tracking Error
There is always the risk that an ETF may not track its underlying index as closely as one would hope; this is known as "tracking error". ETFs that track liquid assets tend to experience less tracking error than ETFs that track illiquid assets.

Another determinant of tracking error is the strategy that the ETF issuer uses to track the index. ETFs will track an index using either a "replication" strategy or a "optimization" strategy. A replication strategy is one where the ETF holds all stocks from all of the companies listed on the index, while an optimization strategy involves holding stocks from a handful of companies listed on the index. With the optimization strategy, the ETF issuer chooses a sampling of stocks that he hopes will accurately track the index. While holding fewer stocks may make the creation/redemption process more efficient from the ETF issuer and AP's perspective, the optimization strategy exposes an ETF to greater tracking error.

Leveraged and Inversely Leveraged ETFs
Leveraged and Inversely Leverage ETFs make up a small percentage of the ETF market. These ETFs are used to track -and then multiply- the performance of an index on a given day. If an index rises by 1% in one day, a 2X leveraged ETF (an ETF that multiplies the returns by 2) tracking that index will rise by 2%. A 3X leveraged ETF will rise 3%, a -2X leveraged ETF will fall 2%, etc.

STAY AWAY FROM LEVERAGED AND INVERSELY LEVERAGED ETFs. Even the smartest and savviest investors are unwilling to take on the increased risk associated with trading these types of ETFs. You should steer clear of them as well.

Taxes
The tax advantages we discussed in our ETF Advantages section are only applicable to equity ETFs (and only to ones tracking non-dividend paying equities). Fixed income ETFs generate capital gains and ETFs tracking other asset classes, such as commodity ETFs and Currency ETFs, receive unique tax treatment. ETFs that do not track equities will not have the same tax advantages as ones that do.