Drawbacks of Exchange-Traded Funds - dummies

By Matt Krantz

Exchange-traded funds (ETFs) are great for many investors who are looking for ways to keep their costs down and simplify their lives. After all, you can buy all your stock and ETF investments from the same brokerage account. But ETFs have drawbacks, too, as the following list makes clear:

  • Commissions: Unlike mutual funds, which can often be bought with no commissions through online brokers or directly from fund companies, ETFs are treated like stocks. That means your online broker’s standard stock commission applies. That can be a deal-killer if you make frequent and small investments. Unless you use an online broker with free trades, you might be better off with an index mutual fund.

  • Temptation: The capability to trade in and out of ETFs is too irresistible for some investors — the kind who can’t keep their fingers off their mouse buttons. If the constant pricing of ETFs encourages you to trade too much and veer off your asset allocation course, you might be better off with mutual funds.

  • Invisible cost — the spread: ETFs come with an invisible, but costly, fee. Just as with stocks, ETFs have a bid and an ask price. The bid is the price other investors are willing to pay for the ETF, and the ask is the price the seller will take. The difference, called the spread, costs investors money.

    For example, say you bought 100 shares of an ETF at the ask price of $100. Most likely, you’d only be able to sell it for $99.90 or less, costing you in effect 10 cents a share. The less popular an ETF, the wider the spread becomes, and the greater this cost becomes. Are you curious about what an ETF’s bid and ask prices are? They’re available from the same places you get stock quotes.

  • Premiums and discounts: ETFs are priced based on what buyers and sellers are willing to pay for the basket of stocks they own. That means the price of an ETF might be greater or less than the value of the stocks it owns.

    When the ETF price is greater than the value of the stocks it owns, that situation is a premium, and when the opposite is true and the ETF is worth less than the value of its stocks, the ETF is said to be trading at a discount.

    Don’t get overly concerned with the premium or discount. Most ETFs’ premiums and discounts are rather small. And for popular ETFs, they are practically nonexistent.