Potential Exchange Traded Funds (ETF) Pitfalls Investors Should Not Overlook

Exchange Traded Funds (ETFs) are open-ended investment funds listed and traded on the stock exchange. They aim to track the performance of an underlying index (like the Straits Times Index) or asset class (like commodities).  A recent popular choice among the investors who are looking to diversify their portfolios without putting in the time and effort that they spend on managing and allocating their investments.

Investors should also note that there are some ETFs, especially within the Specified Investment Products (SIP) classification, that are for investors who are willing to accept the risk of substantial losses up to the principal investment amount, possibly within a very short time frame. Investors should also have sufficient understanding of the product and should possess either a high level of knowledge or sufficient trading experience.

These popular funds are similar to mutual funds but trade like stocks and can act as a great investment vehicle for small and large investors alike. However, there are some factors with ETF that investors must be aware of before jumping in:

  • Trading Fees

    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. ETF transactions, however, incur no sales charge or redemption charge; only a brokerage fee ranging from 0.12% to 0.28% (with minimum commission fees of $10-$28). 

  • Underlying fluctuations and risks:

    Just because an ETF contains more than one underlying position, doesn’t mean that it can’t be affected by volatility.

    The fluctuations or swings will entirely depend on the scope of the fund. If an ETF tracks a broad market index (like S&P 500), it’s likely to be less volatile than an ETF that caters to a specific industry or sector, like oil services 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 funds are the same.

  • Lack of Liquidity:

    Before buying an ETF, one needs to make sure that it is liquid, which means that when you buy a fund, there is enough trading interest that you will be able to get out of it relatively quickly without moving the price.

    The best way to make sure that an ETF is liquid is to study the spreads and the market movements over the week or month.

    Trading ETFs with large spreads eats away at potential returns since they affect the ETF purchase and sales prices.

  • Capital Gains Distributions:

    In certain cases, the ETF will also distribute capital gains to shareholders. Now, shareholders are responsible for paying the capital gains tax. This situation becomes undesirable for ETF holders as it creates a tax liability for the investor.

    It’s usually better if the funds retain those capital gains and invests them, rather than distributing it and create tax problems for the investors. Investors would usually want to re-invest those distributions and for this they’ll need to go back to their brokers to buy more shares, that creates new fees to be incurred by investors.

    It’s also crucial for an investor to learn about the way an ETF treats capital gains distributions before investing in that fund.

  • Loss of Taxable Income Control:

    If the price of the stock goes down, an investor who has bought shares in a pool of individual stocks can sell the shares at a loss. However, the investor who holds the same stock through an ETF doesn’t have the luxury of doing so and reducing total capital gains and taxable income.

    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.

    The ETF determines when to adjust its portfolio, and the investor has to buy or sell an entire lot of stocks, rather than individual names.

 

ETF’s have become very popular and have seen a remarkable growth in many cases. However, there are risks associated with ETF’s that the investor should know before jump into the world of ETF’s. Making sound investment decisions requires knowing all of the facts about a particular investment vehicle, and ETFs are no different.

Written by

Aditya Gupta

Last updated on

October 1st 2019, 6:35 pm

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