ETF Disadvantages

As with any investment strategy, there will always be some disadvantages which must be carefully weighed against the potential for gain. The same holds true for exchange traded funds (ETF). While they are most often seen as a sound long term investment, there may be variables which would work to the disadvantage of an active trader. Following is a brief explanation of ETF’s in general and a bit of information on ETF disadvantages which could affect your decision on whether or not to invest in this particular investment model.

What Exactly Are ETF’s?
Basically an ETF is a fund that simply tracks an index. However, it can be traded much like stocks on the open market and they will typically be bundled securities that can be found within the index they are tracking. They can be handled in much the same way as a stock, which means that an investor can short sell if so desired. ETF’s are traded at any time throughout the day, unlike mutual funds which are only traded once per day. Prices fluctuate which is why there is constant movement in ETF’s and they are more tax efficient and carry lower operating costs than do mutual funds. On the plus side, there are no minimum investments required and no sales loads.

Fees Associated with ETF’s
Unfortunately, an investor would need to go through a broker to purchase an ETF which means that there would be a brokerage fee involved. While the seller wouldn’t incur a fee, the buyer always would which means that every transaction carries a fee on the selling end. Because of their movement and the way in which they are traded throughout the day, a good bit of the investor’s capital could be eaten up in brokerage fees if he/she is not careful. While there is less operational costs involved and they are more tax-efficient, for the active trader an ETF might not be the best investment.

Cannot Reinvest Dividends
Another one of the commonly noted ETF disadvantages is that they cannot reinvest dividends, unlike open ended mutual funds. Dividends are paid quarterly to the owners of shares which prompts the something called a ‘dividend drag.’ Investors need to wait months before being able to reinvest any gains they might have made. Although investors are free to buy and sell (trade) as desired, the actual dividends for those in holdings are only paid four times a year. Of course, the investor is free at that time to take the dividend and reinvest it, it doesn’t have the same fluidity of movement that are inherent in open ended funds.

Trades Based on Forces within a Market
Keep in mind that ETF’s track a market index. They are bought and sold based on what a particular index is doing at any given moment. Even though an investor might buy at a slight discount or a slim premium, the price of the net asset value which underlies the indexed fund is often small. The people who make the biggest profit are thought to be the arbitrageurs who step in when the index is down to bring it back up again.

Even though there are some ETF disadvantages, consider the fact that this is a relatively new concept that is less than two decades old. They have seen major developments within those 18 or so years and are quickly becoming quite popular with investors who don’t want to sit on holdings as long as they would with mutual funds. Although they are traded throughout the day, there will be a brokerage fee when purchasing them. Take that into careful consideration as well before selling current ETF’s to invest in another indexed portfolio.

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