Most people are familiar with the advantages of trading ETFs, such as the low costs, flexibility, and tax efficiency. There are also some disadvantages to be aware of before investing in these products.
ETFs are not always cheaper than mutual funds.
While ETFs typically have lower expense ratios than comparable mutual funds, this is not always the case. For example, Fidelity offers several zero-expense ratio index mutual funds, which are much cheaper to hold than ETFs tracking the same indexes.
ETFs can be more volatile than mutual funds.
It is because they are traded on an exchange and subject to the whims of the market. For example, if there is a sudden sell-off in the market, ETF prices can drop sharply in minutes.
ETFs may have complex structures.
ETFs may have complex structures that make them difficult to understand. For example, some ETFs use derivatives or leverage to achieve their investment objectives. It can make it difficult to determine the actual value of the underlying assets and how they will perform over time.
ETFs may not track their indexes accurately.
They are subject to tracking error, which is the difference between the return of the ETF and the return of its underlying index. It occurs for various reasons, such as expenses, fees, and market forces.
ETFs may be subject to counterparty risk.
It is the risk that the other party in a transaction will not fulfil their obligations. For example, if you buy an ETF traded on an exchange, you rely on the exchange to match you with a seller. If the exchange fails to do so, you may not be able to sell your shares.
ETFs may have high bid-ask spreads.
It is the difference between the highest price a buyer is willing to pay for a share and the lowest price a seller is willing to accept. It occurs because there is often less liquidity in the market for ETFs than there is for stocks. Buyers might have to pay more than they would for a stock, and sellers may have to accept less.
Capital gains taxes may apply to ETFs.
They are sold on an exchange and can be subject to short-term or long-term capital gains taxes. It can eat into your investment returns, especially if you are in a high tax bracket.
ETFs may be challenging to borrow
They are not always available to be borrowed for short selling. As a result, you may have to pay higher interest rates when you borrow them.
You may need a broker to trade ETFs.
If you want to trade ETFs, you will need to open an account with a broker that offers them. It can't be easy if you are not already familiar with the broker.
You may need to pay commissions to trade ETFs.
If you trade ETFs through a broker (you can check here), you will likely have to pay commissions. It can add to the cost of your investment and eat into your returns.
ETFs may not be suitable for all investors.
Before investing in ETFs, you should consider your investment objectives, risk tolerance, and financial situation. It is because ETFs may not be suitable for all investors. For example, if you are retired and relying on investment income to support yourself, ETFs may not be the best investment.
You may lose money investing in ETFs.
As with all investments, there's the risk that you will lose money. It is especially true if you invest in ETFs subject to market volatility or tracking error. Before investing in ETFs, you should consider your risk tolerance and financial situation.
Investors should be aware of these disadvantages before investing in ETFs. While ETFs can offer some benefits, they are not without risk. As with any investment, you should research and consult a financial advisor to determine if ETFs are suitable for you.