Do ETFs Belong in Your Portfolio? - dummies

By Russell Wild

On the plus side of exchange-traded funds (ETFs) there are ultra-low management expenses, super tax efficiency, transparency, and a lot of fancy trading opportunities, such as shorting, if you are so inclined. What about the negatives?

ETF trade commissions

You may have to pay a commission every time you buy and sell an ETF.

Here’s the good news: Trading commissions for stocks and ETFs (it’s the same commission for either) have been dropping faster than the price of desktop computers. What once would have cost you a bundle, now — if you trade online, which you definitely should — is really pin money, perhaps as low as $4 a trade, and sometimes nothing at all.

However, you can’t simply ignore trading commissions. They aren’t always that low, and even $4 a pop can add up. In most cases, you shouldn’t agonize over the cost of trading ETFs; merely keep an eye on them.

ETFs can move money in a flash

The fact that ETFs can be traded throughout the day like stocks makes them, unlike mutual funds, fair game for day-traders and institutional wheeler-dealers.

For the rest of the common folk, there isn’t much about the way that ETFs are bought and sold that makes them especially valuable. Indeed, the ability to trade throughout the day may make you more apt to do so, perhaps selling or buying on impulse. Impulsive investing, although it can get your endorphins pumping, is generally not a profitable way to proceed.

ETF tracking error

At times, the value of the securities held by the ETF may trade above or below the index it follows. This situation is called tracking error. At times, an ETF may also sell at a price that is a tad higher or lower than what that price should be given the prices of all the securities held by the ETF.

This situation is called selling at a premium (when the price of the ETF rides above the value of the securities) or selling at a discount (when the price of the ETF drops below the value of the securities).

Both foreign-stock funds and bond funds are more likely to run off track, either experiencing tracking error or selling at a premium or discount. But the better funds do not run off track to any alarming degree.

This is not, however, something to worry about if you are a buy-and-hold ETF investor.