Exchange Traded Funds (ETFs) have grown enormously in popularity recently and as well they should. Attempting to beat the market with actively managed mutual funds can be an exercise in frustration, as even insiders will admit that most of them actually underperform the market. An ETF merely tracks indexes, thereby affording a much lower expense ratio, leading to a fatter bottom line.
An ETF is a tremendous investment vehicle for average investors; however, just like with any other form of investing, ETFs have advantages and disadvantages as well. Therefore, it is highly advisable for investors to familiarize with potential ETF pitfalls so that an informed strategy can be formulated.
3 Main Problems With ETFs:
- Smorgasbord Of Offerings: ETFs cover the whole gamut of the investing universe, from the universal to the extremely exotic, and everything in between. This simple fact can easily lead to speculation temptation. As the costs of entry and exit are so minimal, investors may feel the urge to trade more frequently than optimal as the market changes, an easy way to sell at market lows and buy at hyped up market highs, a sure fire way to diminish total returns. Sticking with all majors may not be the perfect strategy, as one damaged sector can have a snowballing effect on the whole market, but following too many hunches can also become costly.
- Jim Wiandt, publisher of Exchange Traded Funds Report and Journal of Indexes, has concluded that ETFs have definitely created a large group of investors who have trader orientations.Instead of simply tracking the S & P 500, investors slice and dice with the SPDR S & P 500. He went on to state that there seems to be a disconnect between the sophistication of ETFs and the financial knowledge of some investors.
- ETF Names: ETF names are more for marketing purposes and may not accurately reflect the securities in the portfolio, or the mix. Even very descriptive names can be misleading, therefore relying exclusively on the names rather than burrowing deeper into the details can be a huge mistake. Of particular importance are market cap weights and equal weighting, especially with international ETFs which can give a false sense of diversification by being too heavily weighted into a specific sector. Furthermore, keep in mind that investing in exotic ETFs can mean surrendering some liquidity, as the ETF is only as liquid as the underlying securities.
- Tax Implications: The SPDR Gold Trust, with $70 Billion in assets, is second only the SPDR S & P 500. There are two main types of commodity ETFs. The first type, to which SPDR Gold Trust belongs to, holds actual bullion, and Head of ETF Research Michael Iachini of Charles Swab Investment Advisory will tell you that for tax purposes, it is investors themselves who hold the bullion, which the IRS considers as collectibles that are taxed not at the 15% capital gains rate, but at the ordinary income tax rate of a maximum of 35% if held for less than one year, or 28% if longer. The second type of commodity ETF is the one that uses financial instruments such as futures but do not hold actual bullion. In the second case, only 60% of profits are taxed at the 15% capital gains rate, the remaining 40% at the regular income tax rate. You will also owe taxes to the IRS on unrealized gains, not profits taken. The best strategy for commodity ETFs is to place them in a tax advantaged vehicle, such as an IRA.
By avoiding these 3 main pitfalls of ETF, you can actually enjoy your ETF journey.