May 21, 2013

Weaknesses to be Known Before Investing in Exchange Traded Funds

A small as well as big investor always treats Exchange Traded Funds (ETFs) as a grand investment. Considered similar to standard mutual funds, these funds trade like stocks. However, this does not mean that one can blindly invest in them without knowing about the shortcomings or weaknesses. In fact, a wise investor will always look at both the sides of the coin to gain possible information. After all, complete and precise information acts as a vital decision-making tool for the investors. So, discussed below are some weak aspects of ETFs that every investor needs to know and understand.

Liquidity

Liquidity refers the presence of adequate trading interest to obtain from it quickly without shifting the price, at the time of buy something. This is biggest aspect any stock or fund that is traded publicly. If you trade ETF in a thinly manner, you might run into problems due to investment, as per your position size with regard to the average volume of trading. The existence of big spread difference between the ask and bid prices is the greatest indicator of an illiquid speculation. Therefore, you need to ensure that the ETF in which you are dealing is liquid by observing the spreads as well as market movements over a period of a week or month.

Fluctuations

One reason why ETFs are the preferred choice of investment is that they add to the desired level of diversification to the portfolio of investors. However, it is vital to know that having more than one basic position does not indicate that ETF is free from the effect of volatility. There is huge scope for big fluctuations to take place, whose potential mainly depends on the fund scope. An ETF tracking a specific industry is likely to be more volatile than an ETF tracking s a broad market. This makes it important to be aware of the fund market index and the kind of investment it entails. If it is an international ETF, the country’s fundamentals followed by the ETF are important along with the credit value of the currency. Apart from that, the social and economic volatility also contributes to the success of such funds. So, remember these factors while taking the decisions related to an ETF. In short, you need to know what is being tracked by the ETF along with the associated risks.

Distribution of Capital Gains

There are cases when an exchange traded fund tends to distribute the gains from capital to its shareholders. This is something that is not always in favor of the ETF holders due to the responsibility of paying the tax on capital gains. In such situations, it is preferable to retain the gains and invests them, instead of distributing them to trigger a tax liability. It is obvious that the investors will prefer re-investing the capital gains for which they will need to consult their brokers for purchasing more shares.

Trading Fees

Because an ETF trades like stocks, investors can sell or buy during market hours or can place an advanced order on the trade such as stops and limits. On the other hand, a usual mutual fund is brought after the market shuts down and once the fund’s net asset value is calculated. However, in both the cases, you need to pay a commission. As per the frequency with which you trade an ETF, the trading fees in the form of commission can quickly increase to decrease your investment performance. Therefore, you need to know about the trading fees while investing in ETFs. While choosing between mutual funds and ETFs, know about the different fee structures for each of them.

Author Bio: Sherry Rosen is an investment banker who has worked with a variety of financial firms. Recently, she has become quite interested in the trading of annuities, similar to those that are handled by the financial firm JG Wentworth. Follow her on Twitter @SherryRRosen

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