Exchange-traded funds (ETFs) can be a great investment vehicle for small and large investors alike. These popular funds, which are similar to mutual funds but trade like stocks, have become a popular choice among investors looking to broaden the diversity of their portfolios without increasing the time and effort they have to spend managing their investments proportionally. However, there are some disadvantages that investors need to be aware of before jumping into the world of ETFs. In this article, we will look at some of the potential flaws that investors should be aware of before buying into ETFs. Good information is an investor's most important tool, and it is always important to recognize the risks and limitations of any investment vehicle, particularly one that is extremely popular. Read on to find out what you need to know to make an informed decision.

Trading Fees

One of the biggest advantages of ETFs is that they trade like stocks. An ETF invests in a portfolio of separate companies, typically linked by a common sector or theme. Investors simply buy the ETF in order to reap the benefits of investing in that larger portfolio all at once. As a result of the stock-like nature of ETFs, investors can buy and sell during market hours, as well as put advanced orders on the purchase such as limits and stops. Conversely, a typical mutual fund purchase is made after the market closes, once the net asset value of the fund is calculated.

Every time you buy or sell a stock, you pay a commission. This is also the case when it comes to buying and selling ETFs. Depending on how often you trade an ETF, trading fees can quickly add up and reduce your investment's performance. No-load mutual funds, on the other hand, are sold without a commission or sales charge, which makes them advantageous, in this regard, compared to ETFs. It is important to be aware of trading fees when comparing an investment in ETFs to a similar investment in a mutual fund.

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5 ETF Flaws You Shouldn’t Overlook

If you are deciding between similar ETFs and mutual funds, be aware of the different fee structures of each, including the trading fees. And remember, actively trading ETFs like stocks can severely reduce your investment performance as commissions can quickly pile up.

The specifics of ETF trading fees depend largely upon the funds themselves, as well as the fund providers. Most ETFs charge no more than $10 in fees per order. In many cases, providers like Vanguard and Schwab allow regular customers to buy and sell ETFs without a fee. As ETFs have continued to grow in popularity, there has also been a rise in commission-free funds as well.

It's also important for investors to be aware of an ETF's expense ratio. The expense ratio is a measure of what percentage of a fund's total assets are required to cover various operating expenses each year. While this is not exactly the same as a fee that an investor pays to the fund, it has a similar effect: the higher the expense ratio, the lower the total returns will be for investors. ETFS are known for having very low expense ratios relative to many other investment vehicles. Nonetheless, for investors comparing multiple ETFs, this is something to be aware of.

Underlying Fluctuations

ETFs, like mutual funds, are often lauded for the diversification they offer investors. However, it is important to note that just because an ETF contains more than one underlying position doesn't mean that it can't be affected by volatility. The potential for large swings will mainly depend on the scope of the fund. An ETF that tracks a broad market index such as the S&P 500 is likely to be less volatile than an ETF that tracks a specific industry or sector such as an oil services ETF. Therefore, it is vital to be aware of the fund's focus and what types of investments it includes. As ETFs have continued to grow increasingly specific along with the solidification and popularization of the industry, this has become even more of a concern.

In the case of international or global ETFs, the fundamentals of the country that the ETF is following are important, as is the creditworthiness of the currency in that country. Economic and social instability will also play a huge role in determining the success of any ETF that invests in a particular country or region. These factors must be kept in mind when making decisions regarding the viability of an ETF.

The rule here is to know what the ETF is tracking and understand the underlying risks associated with it. Don't be lulled into thinking that because some ETFs offer low volatility that all of these funds are the same.

Liquidity

The biggest factor in an ETF, stock or anything else that is traded publicly is liquidity. Liquidity means that when you buy something, there is enough trading interest that you will be able to get out of it relatively quickly without moving the price.

If an ETF is thinly traded, there can be problems getting out of the investment, depending on the size of your position in relation to the average trading volume. The biggest sign of an illiquid investment is large spreads between the bid and ask. You need to make sure an ETF is liquid before buying it, and the best way to do this is to study the spreads and the market movements over a week or month.

The rule here is to make sure that the ETF you are interested in does not have large spreads between the bid and ask prices.

Capital Gains Distributions

In some cases, an ETF will distribute capital gains to shareholders. This is not always desirable for ETF holders, as shareholders are responsible for paying the capital gains tax. It is usually better that the fund retains the capital gains and invests them, rather than distributing them and creating a tax liability for the investor. Investors will usually want to re-invest those capital gains distributions and, in order to do this, they will need to go back to their brokers to buy more shares, which creates new fees.

Because different ETFs treat capital gains distributions in various ways, it can be a challenge for investors to stay apprised of the funds they take part in. Staying organized and watchful is helpful, and it's also crucial for an investor to learn about the way an ETF treats capital gains distributions before investing in that fund.

Lump Sum vs. Dollar-Cost Averaging

Buying an ETF with a lump sum is simple. Say $10,000 is what you want to invest in a particular ETF. You calculate how many shares you can buy and what the cost of the commission will be and you get a certain number of shares for your money.

However, there is also the tried-and-true small investor's way of building a position: dollar-cost averaging. With this method, you take the same $10,000 and invest it in monthly increments of, say, $1,000. It's called dollar-cost averaging because in some months you will buy fewer shares with that $1,000 as a result of the price being higher. In other months, the share prices will be lower and you will be able to buy more shares.

Of course, the big problem with this strategy is that ETFs are traded like stocks; therefore, every time you want to purchase $1,000 worth of that particular ETF, you have to pay your broker a commission to do so. As a result, it can become more costly to build a position in an ETF with monthly investments. For this reason, trading an ETF favors the lump sum approach.

The rule here is to try to invest a lump sum at one time to cut down on brokerage fees. If you're looking to invest in ETFs, Investopedia has created a list of the best online stock brokers for stock trading where you can find the information you need on the various fees that can occur.

Leveraged ETFs

When it comes to risk considerations, many investors opt for ETFs because they feel that they are less risky than other modes of investment. We've already addressed issues of volatility above, but it's important to recognize that certain classes of ETFs are inherently significantly more risky as investments as compared with others. Leveraged ETFs are a good example. These ETFs tend to experience value decay as time goes on and due to daily resets. This can happen even as an underlying index is thriving. Many analysts caution investors against buying leveraged ETFs at all; those investors that do take this approach should watch their investments carefully and be mindful of the risks.

ETFs Vs. ETNs

Because they look similar on the page, ETFs and exchange-traded notes (ETNs) are frequently confused. However, investors should remember that these are very different investment vehicles. ETNs also have a stated strategy, they also track an underlying index of commodities or stocks, and they also have an expense ratio, among other features. Nonetheless, ETNs tend to have a different set of risks from ETFs. ETNs face the risk of solvency of an issuing company; if an issuing bank for an ETN declares bankruptcy, investors are often out of luck. It's a different risk from those associated with ETFs, and it's something that investors eager to jump on board the ETF trend may not be aware of.

Loss of Taxable Income Control

An investor who buys shares in a pool of different individual stocks has more flexibility than one who buys the same group of stocks in an ETF. One way that this disadvantages the ETF investor is in his or her ability to control tax loss harvesting. If the price of a stock goes down, an investor can sell shares at a loss, thereby reducing total capital gains and taxable income, to a certain extent. Those investors holding the same stock through an ETF don't have the same luxury; the ETF determines when to adjust its portfolio, and the investor has to buy or sell the entire lot of stocks, rather than individual names.

Deviation Between Price and Underlying Value

Like stocks, the price of an ETF can sometimes be different from that ETF's underlying value. This can lead to situations in which an investor might actually pay a premium above and beyond the cost of the underlying stocks or commodities in an ETF portfolio just to buy that ETF. This is uncommon and is typically corrected over time, but it's important to recognize as a risk one takes when buying or selling an ETF.

Issues of Control

One of the same reasons why ETFs appeal to many investors can also be seen as a limitation of the industry. Investors typically do not have a say in the individual stocks in an ETF's underlying index. This means that an investor looking to avoid a particular company or industry for a reason such as moral conflict does not have the same level of control as an investor focused on individual stocks. An ETF investor does not have to take the time to select the individual stocks making up the portfolio; on the other hand, the investor cannot exclude stocks without eliminating his or her investment in the entire ETF.

ETF Performance Expectations

While it's not a flaw in the same sense as some of the items above, investors should go into ETF investing with an accurate idea of what to expect from performance. Mutual funds are known to underperform. ETFs are most often linked to a benchmarking index, meaning that they are often designed to not outperform that index. Investors looking for this type of outperformance (which also, of course, carries added risks) should perhaps look to other opportunities.

The Bottom Line

Now that you know the risks that come with ETFs, you can make better investment decisions. ETFs have seen spectacular growth in popularity and, in many cases, this popularity is well deserved. But, like all good things, ETFs also have their drawbacks. Making sound investment decisions requires knowing all of the facts about a particular investment vehicle – ETFs are no different. Knowing the disadvantages will help steer you away from potential pitfalls and, if all goes well, toward tidy profits.