While reading about exchange-traded funds (ETFs) it may be hard to find any disadvantages that come with them. All the articles seem to be all about the advantages of ETFs.

Yet every investment has a downside; there is no one perfect investment product.

So that you can fully understand what you are investing in, let’s take a look at both the good and the bad of ETFs. Then you can make an informed decision about the right investment for you.

Watch Those Fees

One of the great advantages of ETFs are the low fees that accompany them. ETFs charge just a fraction of what a mutual fund charges. Plus, ETFs don’t have front loads or deferred loads, so all of your money gets invested.

The disadvantage with ETF fees is that you do pay a commission charge every time you purchase shares of an ETF. If you are dollar cost averaging every month this can add up. Additionally, if you reinvest dividends then you would pay a commission on that reinvestment versus with a mutual fund they reinvest the dividends with no additional fee. (For more, see: ETF Fees: How to Keep Them as Low as Possible.)

On the upside, you can get around the commission charge by picking a brokerage that either offers some ETFs commission free or that waive the reinvestment fee from dividends.

Tax Efficient? Not Always

ETF’s are tax efficient. This is due mainly to the fact that they allow for in-kind exchanges for authorized participants (AP). What this means is that an AP can exchange an ETF share for the actual shares of the companies it owns within the ETF. They can then turn around and sell them on the market.

This exchanges makes it so the actual ETF does not have to sell shares thus eliminating most capital gains. This means that you will not get a capital gains distribution like you do from a mutual fund.

On the flip side, you can incur capital gains if the ETF has to change the index due to an addition or subtraction in the underlying index. (For more, see: ETFs Can Be Tax Efficient: Here’s How.)

There are some other circumstances that can cause an ETF to have capital gains. Those include some international funds, as not all countries allow for in-kind distribution, actively managed ETFs or leveraged ETFs. If you are investing in any of these either ensure they are in a non-taxable account or save extra money for the tax payments.

Getting in Over Your Head

Because ETFs are traded like stocks, you can add on advanced strategies to ETFs such as options, short selling and stop-loss orders.

Depending on your experience level this can be an advantage or a disadvantage. If you are not experienced in these strategies, you can quickly lose your money. If you are in a mutual fund, you don’t have that option so you don’t take on the extra risk. (For more, see: Top ETFs and What They Track.)

On the other hand, if you do understand these techniques then you could increase your return on your investment. For example, you could write covered calls on your ETF for added income. With the stop-loss orders you could have more control over what price you buy at. Instead of getting in at the given price on the day, you could place an order at a specific price and only buy then. However, this does encourage market timing, which can lead to not getting market return.

Overall, with the added trading capabilities you need to ensure they are good for your skill set and that they won’t harm your return.

Niche Investments

ETFs make it easy to invest in one sector, one country or with one strategy. Which is great because you can diversify quickly and gain exposure where you think the market may turn next. 

However, it does come with some drawbacks. Many of these niche funds are very small. This can cause liquidity issues if you need to sell. If the bid/ask spread is large or the amount of assets in the ETF is small you need to be cautious about the liquidity risks. (For more, see: 4 Ways to Use ETFs in Your Portfolio.)

Another disadvantage is that it's easy to increase the overall risk of your portfolio by getting into niche funds. If you are not careful you can alter your asset allocation by trading in and out of ETFs, or increase risk by buying into leveraged ETFs.

More Advantages of ETFs

  • Unlike mutual funds, you don’t need a large sum of money to get started. If you have enough to buy a share and cover commission costs, then you can get started investing today with ETFs.
  • Because of the structure of an ETF they don’t have to keep money on hand to cover redemptions from other investors getting out. Thus the money is fully invested all the time, reducing cash drag.

More Disadvantages of ETFs

  • The stability of the company offering the ETF can play a big part in the success of the ETF. Amazingly, it is rather easy to start an ETF, thus you will get smaller companies offering ETFs. While this is great to get new companies in the investment space, it can cause problems for the life of your ETF. If the ETF does not take off right away, then it can shut down because it does not make enough. Larger companies are able to absorb the cost of the ETF while it grows. If an ETF has low assets, make sure the company can support it.
  • While most ETFs trade at net asset value (NAV) because of in-kind redemptions, it's possible for an ETF to not trade at the NAV. This is especially true for actively managed, leveraged and international ETFs because of the inability for an AP to make in-kind redemptions.
  • Actively managed ETFs are starting to get just as pricey as mutual funds. Watch the expense ratio before investing.

The Bottom Line

ETFs have become so popular because of their versatility and variety, but that doesn't mean they're always the right choice and that they're all created equally. Just make sure you are aware of the advantages and disadvantages before you invest. As always, consider consulting a financial advisor to help you make the best choice. (For more, see: Advantages and Disadvantages of ETFs.)

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