For decades, mutual funds have offered professional portfolio management, diversification and convenience to investors who lack the time or means to trade their own portfolios profitably. In recent years, a new breed of mutual funds has appeared, offering many of the same advantages of traditional open-ended funds with much greater liquidity. These funds, known as exchange traded funds (ETFs), trade on public exchanges and can be bought and sold during market hours, just as stocks can. The rise in popularity of these funds, however, has also created a fair amount of misinformation about ETFs. This article examines some of the common misconceptions surrounding ETFs and how they work.

Leverage Is Always a Good Thing
A variation of ETFs can employ leverage of varying degrees in order to achieve returns that are, either directly or inversely, proportionately greater than those of the underlying index, sector or group of securities upon which they are based. Most of these funds are usually leveraged by a factor of up to three, which can amplify the gains posted by the underlying vehicles and provide huge, quick profits for investors. Of course, leverage works both ways, and those who bet wrong can sustain big losses in a hurry.

The costs of maintaining leveraged positions in these funds are also quite substantial in some cases. Portfolio managers are required to purchase positions when prices are high, and sell when they are low, in order to rebalance their holdings, which can substantially erode the returns posted by the fund in a relatively short period of time. However, perhaps most importantly, many leveraged funds simply don't post returns that are in tune with their proportion of leverage over periods of time greater than one day, due to the effect of compounding returns that mathematically disrupts the fund's ability to follow its index or other benchmark.

There Are ETFs for Every Index
Many investors believe that there is an ETF available for every index or sector in existence, but this is not the case. There are many indexes for securities or economic sectors in less-developed countries and regions that do not have any sector funds based upon them (such as the CNX Service Sector or Mid-Cap Indexes in India). Furthermore, ETFs do not always purchase all of the securities that make up an index or sector, especially if it is comprised of several thousand securities, such as the Wilshire 5000 Index. Funds that follow indexes like this often only purchase a sampling of all of the securities in the sector or index and use derivatives that can augment the returns posted by the fund. In this manner, the fund can track the return of the index or benchmark closely in an economical way.

ETFs Only Track Indexes
Another popular misconception about ETFs is that they only track indexes. ETFs can track sectors, such as technology and health care, commodities such as real estate and precious metals and currencies. Today, few types of assets or sectors do not have an ETF covering them in some form.

ETFs Always Have Lower Fees than Mutual Funds
ETFs typically can be purchased and sold for the same kind of commission that is charged for trading stocks or other securities. For this reason, they can be much cheaper to buy than open-ended mutual funds - as long as a large amount is being traded. For example, a $100,000 investment may be made into an ETF for a $10 commission online, whereas a load fund would charge anywhere from 1 to 6% of assets. ETFs are not good choices, however, for small periodic investments, such as a $100 per month dollar-cost averaging program, where the same commission would have to be paid for each purchase. ETFs do not offer breakpoint sales like traditional load funds.

ETFs Are Always Passively Managed
Although many ETFs still resemble UITs, in that they are comprised of a set portfolio of securities that is periodically reset, the world of ETFs consists of more than just SPDRS, Diamonds and Cubes. Actively managed ETFs have made an appearance in recent years and will most likely continue to gain traction in the future.

Other Misconceptions and Limitations
Although the liquidity and efficiency of ETFs are attractive, critics maintain that they also undermine the traditional purpose of mutual funds as longer term investments by allowing investors to trade them intraday like any other publicly traded security. Investors who have to pay a 4 to 5% sales charge will be much less likely to liquidate their positions when the share price declines two weeks after purchase than they might have if they only had to pay a $10 or $20 commission to their online broker. Short-term trading also negates the tax liquidity found in these vehicles.

Furthermore, there are times when the net asset value of an ETF can vary by a few percentage points from its actual closing price due to portfolio inefficiencies. There has also been speculation that ETFs have been used to manipulate the market, and this practice may have contributed to the market meltdown in 2008. Finally, some analysts feel that many ETFs do not provide adequate diversification on a per-fund basis. Some funds tend to focus heavily on a small number of stocks or else invest in a fairly narrow segment of securities, such as biotechnology stocks. Although these funds are useful in some instances, they should not be used by investors seeking broad exposure to the markets.

The Bottom Line
ETFs offer a number of advantages over traditional open-ended mutual funds in many respects, such as liquidity, tax efficiency, and low fees and commissions. There is, however, a fair amount of misinformation floating around about these funds. They do not cover every index and sector, and there are some limitations to their efficiency and diversification. Their liquidity can also encourage short-term trading that may not be appropriate for some investors.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.