In last decade, specialty ETFs (Exchange Traded Funds) are probably the hottest thing to hit Wall Street since the rise of the discount brokers in the mid 1990s.
Initially, ETFs were not very popular because they only tracked the performance of a few stock market indices.
However, in today’s investing world, ETFs — and especially the sector based ETFs — couldn’t be more popular! In fact, they’re so popular that if you can come up with the most screwball of an investment idea, I can almost guarantee that an ETF is available for you to buy through your broker.
Whether you want to buy U.S. Treasury bonds, buy soybeans, or even buy a combination of emerging market currencies, there is probably an ETF already out there with your name on it. Just do a quick Google search with the words “ETF” and “your investment choice”, and Google will hook you up.
However, like all things in life, you must consider the pros and cons. Investing is not a game, so you should consider the advantages and disadvantages of ETFs very carefully before using them.
Advantages of ETFs
- Instant diversification. Just like index funds, a diversified ETF is a cheap and efficient way to reduce your risk. If owning just 10 stocks keeps you awake at night or you believe that you can’t beat the S&P 500, ETFs that track a stock market index are an excellent place to begin your search.
- ETFs trade just like stocks. Unlike mutual funds or index funds, ETFs trade on an exchange so you can buy them at any time during the day. No longer do you have to wait until the market closes to buy or sell your holdings.
- Low expense ratios. The more basic index ETFs are fairly cheap, while the more esoteric ETFs can be rather expensive. Occasionally, ETFs can be less expensive than index funds. If you’re an avid index fund investor, it could potentially benefit you in the long run if a similarly diversified ETF has a lower expense ratio and offers commission free trades.
- Can pick specific sectors and still stay diversified. Certain ETFs will allow you to buy multiple stocks in a specific sector, but still reduce your risk since you don’t have to pick one individual stock. For example, if you feel the financial sector is a good investment, you can buy the XLF (a collection of various financial companies) instead of just buying J.P. Morgan or Bank of America.
- Invest in esoteric or specialty markets. You can make an investment in almost anything using an ETF. Gold, soybeans, light sweet crude, TIPs, or the U.S. Dollar. The world is your oyster – so to speak!
Disadvantages of ETFs
- Frequently used by the Mega Daytraders. ETFs, particularly the ultra leveraged (2x or 3x) ETFs, offer tremendous earning potential for aggressive daytraders and/or swing traders. If you trade these, beware you are swimming in the deep end of the pool and 10% intraday price swings are commonplace.
- Diversification can reduce potential profits. If you’re an aggressive trader, diversification can sometimes be a bad thing. When holding a large group of stocks, your portfolio can only go as high as your worst performing investment. Plus, why would you want to pay a management fee on a 3x leveraged ETF when certain high beta stocks just as volatile without paying the management fees.
- All ETFs are not created equal. ETFs are an investment product sold by investment management companies, so some will be more costly than others. Generally, the more esoteric the ETF, the higher the management fees will be (index ETFs are cheap vs. 3x leveraged ETFs are expensive). Some companies even have competing ETFs, so it’s best to shop around to find the lowest expense ratios. Simply enter your chosen ETFs into Yahoo Finance or Google Finance, and it will display the expense ratio under the ETFs profile or prospectus.
- Liquidity issues. Some ETFs are not frequently traded, and the low volume can result in a significant gap between the bid and ask price. For example, an actively traded ETF differs by $0.01. Whereas an inactively traded ETF may vary as much as $0.25 to $0.50.
- Investing in items you don’t understand. One of the cardinal rules of investing is to understand what you’re investing in. Just because you have the option to use ETFs as an investment vehicle to become a Forex trader or a commodities futures trader, it doesn’t mean it’s a good idea. In fact, it’s likely a bad idea since and you now have a 50/50 chance of losing your money. That’s called gambling! If you must, practice your trading skills first in a stock market simulator.
Got any other ideas on ETFs? Do you use them as long term investments or short term trading vehicles? Have you began replacing your traditional index funds with ETFs that track an index because they are more cost effective?