Why Exchange-Traded Funds May Not Be Right for You

The Disadvantages of ETFs

Although exchange-traded funds have many advantages, like most investments, they carry disadvantages as well. The following disadvantages of ETFs will give you some added clarity on these vehicles, before taking the plunge.

International Limitations

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While the U.S. boasts many ETF offerings, other countries have very few. Furthermore, most foreign ETFs are strictly large-cap products. So if you wish to diversify into small- and mid-cap products, you may be out of luck, outside the U.S.

Low Trading Volumes

The advantage of purchasing an ETF over an index or equity diminishes when ETFs demonstrate low trading volumes, because the bid-ask spread can be too wide to be cost-effective. Barring any unforeseen news or circumstances, market makers tend to be tighter on securities that are more liquid.

Long Investment Horizon

While intra-day trading opportunities created by ETFs might benefit short-term ETF traders, they night not serve a long-term investor’s strategic outlook.

Inactivity

Some ETFs aren’t as actively traded as others. This might occur  because of sector or regional issues. Consequently, it may be prudent for some investors to consider managed funds, where trading activity levels are typically higher.

Tax Implications

While some U.S. ETFs carry negative tax implications, certain foreign ETFs can offer tax advantages to an international portfolio, because tax laws vary from country to country. Therefore it might be beneficial to your tax situation, to contemplate foreign investments.

Always Be Aware of Your Risks

As with any investment—a company stock, an index, or other options—make sure you thoroughly research any exchange traded fund before making any trades, either long or short. Conduct your due diligence, watch how an ETF or ETN reacts to different market conditions, take a look under the hood, and see what's in the fund or note. Make sure to consult a broker, a financial advisor, or another financial industry professional if you have any questions or concerns.