An exchange-traded fund (ETF) is a hybrid of stocks and indexed mutual funds. They are purchased through brokers and traded through exchanges just as a stock would be, but they represent a basket of holdings designed to track a particular index or price. The underlying asset could be stocks, bonds, commodity contracts, real estate, precious metals, or combinations of assets.
ETFs are useful to assemble a diversified portfolio at a relatively low cost. However, not all ETFs are the same, and the wrong choices could cost you significant money. Consider these factors as you review your ETF options.
- Fee Structures – In general, ETFs have favorable fee structures, but low fees are not guaranteed. Expense ratios can be deceptively high, approaching that of a corresponding index fund. If that is the case and you do not need the trading convenience, the index fund may be a better choice. If you find index funds that track the same index but have different fee structures, look very closely to see what you are getting for your money.
- Active Vs. Passive Management – ETF funds can be either actively managed with managers making trades in the underlying assets to meet or exceed the desired index, or be passively managed by an algorithm approach with limited intervention. Higher levels of management require higher fees.
Look at the performance of any ETF to determine whether the extra fees are paying off in greater performance. More hands-on management does not guarantee better performance — in fact, passively managed funds can often beat actively managed funds, especially in a rising economy.
- Liquidity – Size does not matter with an ETF once it gets beyond a certain threshold, but it is difficult for an ETF to operate with low liquidity. There will be a risk premium and a higher price built into the ETF, and it may be more difficult to trade.
- Taxes – Understand the tax implications of your ETF, because it is not always straightforward. Taxes generally relate to the underlying holdings and not the fund itself. For example, a gold ETF that invests in physical gold bars will be taxed as a collectible and not at the lower capital gains rate, even though you held it for over a year and sold it as if it were a stock.
- Higher Risk ETFs – Leveraged ETFs are considerably higher risk than the average ETF. As with leveraged stock purchases, you are multiplying the effect of the results whether they are gains or losses. Inverse ETFs effectively bet against the rise of value of an index, so returns increase as the index declines. Both vehicles are highly speculative and tend to have high fees due to active management.
There is no harm in investing in these as long as you understand the risk and speculative nature, but you should at least ask if other higher risk investments are better for your portfolio balance.
Regardless of the ETFs you have, avoid the temptation to trade them excessively. Generally, that just racks up excessive fees and charges — and avoiding those is one of the reasons to invest in ETFs in the first place.
Several websites contain tools to help you screen and evaluate ETFs, such as etfdb.com with their online ETF screener. Do not go on the name alone. For example, an ETF with "oil" in the name does not necessarily track crude oil prices. It may track other parts of the oil supply chain and distribution, or equipment manufacturers that supply the oil industry.
ETFs can be excellent low-cost investments, or they can be disproportionately expensive money drains. Do your homework on any ETFs you want to invest in so you will be able to spot the difference.