Why are ETFs dangerous?

danger etfsExchange-traded funds, otherwise known as ETFs have become investors’ new best friends in the investment world. Investors have spent over $1 trillion into these investment vehicles. There are over 1,000 ETFs available that range in sectors from equities, to fixed income, to commodities.

Most ETFs mirror broadly diversified indexes such as the S & P 500. ETFs are like mutual funds that trade like stocks.

The benefits of ETFs are well known.

  • They are tax efficient
  • They provide immediate diversification to a portfolio through a single transaction
  • They are relatively inexpensive compared to most mutual funds.
  • ETFs can also be bought and sold quickly on the open market. However, as Utpal Bhattacharya, a finance professor at Indiana University explains, the easy to trade index linked securities allow investors to make bets on market cycles and those bets are just that…. bets.

As the market for ETFs becomes greater, the newer ETFs become more exotic. For example, many institutions now offer leveraged ETFs or inverse ETFs that are tied to shorting small and large market sectors. The sectors that ETFs track are also becoming more nuanced as well like the Real Estate Investment Trust (REIT) markets. Moreover, more than half of the currently available ETFs were launched within the last three years making them also untested. Finally, ETFs can have high commissions. Many are sold through discretionary accounts that have high annual fees in addition to the per trade transaction if bought at a brokerage firm.

Investors should be careful to fully understand the risks associated with these products before investing in them. In addition, investors should not try to become active traders with products that were designed to lugubriously track the on-goings of the broader markets. A good rule of thumb: If you can’t understand what you are investing in, it’s probably not the right investment for you.

To learn more about Adam Gana, visit his site at www.ganalawfirm.com.

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