Exchange-traded funds (ETFs) can be a great way for both small and big buyers to put their money to work. These popular funds, which are like mutual funds but trade like stocks, have become a popular choice for investors who want to diversify their portfolios without spending more time and effort handling and dividing their investments.
ETFs are a way to own a group of stocks or bonds. The value of an ETF can go up if the assets it holds go up in value. Also, investments that bring in money, like interest or profits, can be set to automatically put that money back into the fund. Before investing in ETFs, however, buyers should be aware of a few things that could go wrong.
KEY TAKEAWAYS
- Exchange-traded funds (ETFs) have become a very popular way for both active and passive buyers to put their money to work.
- ETFs give investors low-cost access to a wide range of asset types, industry areas, and foreign markets. However, they do come with some risks that aren’t found in other investments.
- It’s important to know how ETF trading works so that you won’t be caught off guard if something goes wrong.
One of the best things about ETFs is that they can be bought and sold like stocks. An ETF is a way to invest in a group of different companies that are usually related to the same industry or theme. Investors just buy the ETF to get all the benefits of buying in that bigger portfolio at once. Because ETFs are like stocks, buyers can buy and sell them during market hours and place orders ahead of time to buy them, such as caps and stops.
On the other hand, most mutual fund purchases happen after the market closes, when the fund’s net asset value has been established. You might have to pay a fee every time you buy or sell a stock.
This is also true when buying and selling ETFs. Depending on how often you buy and sell an ETF, trading fees can add up fast and hurt the success of your investment. On the other hand, no-load mutual funds are sold without a fee or sales charge, which makes them better in this way than ETFs.
When comparing an ETF investment to a similar investment in a mutual fund, it is important to be aware of the trade fees.
There are a lot of online companies that let you trade stocks and ETFs with no fees. Note, though, that you may still pay a secret fee in the form of payment for order flow (PFOF). This controversial practice sends your orders to a specific partner instead of letting the market fight for your order at the best price possible.
If you are trying to decide between similar ETFs and mutual funds, you should know that each has a different fee structure. For example, actively managed ETFs may have trade fees. Remember that actively trading ETFs, just like actively trading stocks, can hurt your investment success because fees add up quickly.
Each ETF also has something called a cost ratio. The expense ratio is a way to figure out how much of a fund’s overall assets are needed each year to pay for its running costs.
Even though this isn’t exactly the same as a fee that an investor pays to the fund, it has a similar effect: the higher the cost ratio, the lower the total profits for investors.
ETFs are known to have very low-cost rates compared to many other types of investments, but they are still something to think about, especially when comparing ETFs that are otherwise very similar.
Changes and risks at the bottom
Like mutual funds, ETFs are often praised for giving buyers a wide range of investments to choose from. But it’s important to keep in mind that just because an ETF has more than one base position doesn’t mean it can’t go up and down. Most of the time, big changes will rest on how big the fund is. An ETF that follows a broad market measure like the S&P 500 is likely to be less unpredictable than an ETF that follows a specific business or area, like an oil services ETF.
So, it’s important to know what the fund is trying to do and what kinds of investments it has. As ETFs have continued to get more specialized and the industry has become more stable and popular, this has become an even bigger worry.
When it comes to foreign or global ETFs, the fundamentals of the country being tracked and the trustworthiness of the currency in that country are important. Any ETF that invests in a certain country or area will also depend a lot on how stable the economy and society are there. When deciding whether or not an ETF will work, you should keep these things in mind.
The rule here is that you need to know what the ETF is tracking and what the risks are. Don’t think that because some ETFs have low fluctuation that they are all the same.
Tracking error shows how closely an index ETF follows its standard index. Those with bigger tracking mistakes might have risks that are hard to see.
Low Liquidity
Liquidity is a very important part of buying an ETF, a stock, or anything else that can be bought and sold openly. When something is liquid, there is enough interest in buying and selling it that you can sell it quickly without changing the price.
If an ETF doesn’t get much trading, it might be hard to get out of it, based on how big your account is compared to the average trading volume. Large gaps between the bid and the asking price are the best way to tell if an investment is hard to sell. Before you buy an ETF, you should make sure it is liquid. The best way to do this is to look at the gaps and how the market moves over a week or a month.
Make sure that the difference between the bid and ask prices for the ETF you are interested in is not too big. When spreads are tighter, there is more liquidity, which means there is less risk when you join and leave a trade.
Distributions of Gains on Capital
In some cases, an ETF will give its owners a share of its capital gains. This is not always what ETF owners want, since they are the ones who have to pay the capital gains tax.
Most of the time, it is better for the fund to keep the capital gains and spend them instead of giving them out and making the owner pay taxes on them.
Most investors will want to reinvest their capital gains payments. To do this, they will need to go back to their brokers to buy more shares, which will result in new fees.
Because different ETFs handle payments of capital gains in different ways, it can be hard for buyers to keep up with the funds in which they invest. Before buying in an ETF, an investor should also find out how the fund handles capital gains payments.
Lump Sum vs. Dollar-Cost Averaging
Say you want to put $5,000 or $10,000 in an index ETF like the SPDR S&P 500 ETF (SPY), but you don’t know if you should do it all at once or spread it out over time. Because there are more no-fee ETFs now than there used to be, broker fees aren’t as important as they used to be.
When you spend a lump sum, you can put all of your money to work right away. This is great when the market is going up, but it might not be the best thing to do if the market looks like it’s about to peak or is especially volatile.
With a dollar-cost average, you put the $5,000 or $10,000 over a number of months. This approach works well if the market goes down or is choppy, but if the market goes up while only part of your money is involved, you lose the chance to make more money. Even small commissions can add up if you place a lot of buy orders unless your exchange doesn’t charge fees.
Leveraged ETFs
When it comes to risk, a lot of buyers choose ETFs because they think they are safer than other ways to spend. We’ve already talked about volatility, but it’s still important to know that some types of ETFs are much riskier options than others.
One example is leveraged ETFs. The value of these ETFs tends to go down over time because they restart every day. This can happen even if the measure it is based on is doing well. Analysts often warn people not to buy leveraged ETFs at all. Investors who do this should keep a close eye on their finances and be aware of the risks.
Some ETFs are also negative, which means that they move in the opposite way of their reference or standard. The returns on leveraged opposite ETFs can be minus 2 or 3 times the standard. opposite ETFs lose value over time because of how they are set up.
ETFs vs. ETNs
People often mix up exchange-traded funds (ETFs) and exchange-traded notes (ETNs) because they look the same on the page. But buyers should keep in mind that these are two very different ways to put money to work. ETNs can have a clear plan, follow an average of stocks or commodities, and charge fees, among other things.
Still, ETNs and ETFs tend to have different kinds of risks. ETNs are at risk if the company that issues them goes bankrupt. If an ETN’s issuing bank goes into failure or, worse, goes bankrupt, buyers often have no choice but to lose their money.
It’s a different risk than those that come with ETFs, and buyers who want to get in on the ETF trend might not know about it.
Less taxable income More freedom
A person who buys shares in a group of different stocks has more options than someone who buys the same group of stocks in an exchange-traded fund (ETF). One way this hurts ETF investors is that they can’t control tax-loss harvesting as well as they could. If the price of a stock goes down, an owner can sell shares at a loss. This cuts down on overall capital gains and taxed income to some extent.
Investors who keep the same stock through an ETF don’t have the same freedom. The ETF decides when to make changes to its portfolio, and the user has to buy or sell a whole group of stocks instead of just one.
ETF Premium to Underlying Value (or Discount)
Like with stocks, the price of an ETF is not always the same as its real value. This means that an owner might have to pay more than the price of the stocks or commodities that make up an ETF’s portfolio just to buy that ETF.
This happens rarely and usually gets fixed over time, but it’s important to know that it’s a risk you take when you buy or sell an ETF. Compare an ETF’s difference from its net asset value (NAV) to see if there are any problems. If its market price is always different from its NAV, there may be something fishy going on.
Questions of power
One of the reasons why many buyers like ETFs can also be seen as a weakness of the business. Investors usually don’t have a say in which stocks make up the index that an ETF tracks. This means that an investor who wants to stay away from a certain company or business for moral reasons doesn’t have as much power as an investor who focuses on individual stocks.
An ETF investor doesn’t have to take the time to choose each stock that goes into the portfolio. On the other hand, the investor can’t leave out any stocks without giving up their whole investment in the ETF.
Expectations for ETF Performance
Even though this isn’t a problem in the same way as some of the other things we’ve talked about, buyers should know what to expect from the results of ETFs.
Most ETFs are tied to a measuring index, which means that they are often made so that they don’t do better than that index. Investors who want this kind of outperformance (which comes with more risks, of course) might want to look for other options.
What does the term “ETF liquidity” mean?
When dealing in exchange-traded funds (ETFs), liquidity is an important thing to think about. There are a number of reasons why ETFs have different trading patterns. Investing in an ETF with low liquidity may cost you in the form of a bigger bid-ask gap, fewer chances to trade in a profitable way, or, in the worst case, not being able to get your money out of the account during a big market crash.
Are exchange-traded funds (ETFs) better than stocks?
ETFs are groups of stocks or other securities, so they are usually well-balanced. However, there are some ETFs that invest in very dangerous areas or use higher-risk tactics like leverage. For example, a leveraged ETF that tracks material prices may be more unpredictable and therefore risky than a stable blue chip.
What is the tracking mistake of an ETF?
The tracking error of an exchange-traded fund (ETF) is the difference between its results and those of the standard index it is based on. Tracking mistakes are usually small, and the biggest ETFs that are owned by a lot of people have the smallest tracking errors.
Why can you only day trade with inverse and leveraged ETFs?
Options and short-term forwards are two types of derivative contracts that are often used by inverse and leveraged ETFs to reach their goals. Because of this, these types of products tend to lose value over time, no matter what happens to the index or standard that the ETF follows. Because of this, these goods are only for day traders and other people who only hold them for a short time.
In conclusion
Now that you know the risks of ETFs, you can make better choices about how to spend. ETFs have become very famous in a very short amount of time, and in many cases, they deserve to be. ETFs are great, but like all good things, they also have some problems.
To make good choices about investments, you need to know everything there is to know about them. ETFs are no different. Knowing the cons will help you avoid problems and, if everything goes well, lead you to nice earnings.
