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Is There a Downside to Exchange Traded Funds: What is It?

written by: Tim Plaehn•edited by: Jason C. Chavis•updated: 6/29/2011

Is there a downside to Exchange Traded Funds? These popular investment funds have some cons as well as pros. There are several circumstances where investing in ETFs may not be the right choice.

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    Exchange Traded Funds

    Exchange traded funds -- ETFs -- have become a very popular way to invest. ETFs are available to provide investors access to stocks, bonds, international markets, currencies and commodities. In spite of the popularity and flexibility, is there a downside to exchange traded funds?

    ETF investing might not be the right choice for all investors. It is also possible for an investor to use the flexibility and choices in the ETF market to cause significant losses in his investment portfolio. The following sections discuss what can go wrong with ETF investing. Check if any of the items affect your investing style.

    An investor considering ETF investing should also look at the funds available as index mutual funds. Both types offer low expenses and many track the same stock and/or bond indexes.

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    Over Trading

    A big danger with ETF investing is the temptation to over trade. It is extremely easy to buy and sell ETF shares through an online stock brokerage account. The investor or trader that starts chasing the current hot ETF will end up purchasing shares just as the fund peaks in value and takes a down turn. Then he will be off to the next hot ETF.

    The more exotic, inverse and leveraged ETFs pose extra risk to investors. The Morningstar website bluntly says these types of funds are portfolio killers. Inverse ETFs will move up in value when the tracked index or security price declines. Leveraged ETFs are designed to have daily price moves two or three times the value change of the specified ETF. These funds are best used by short term traders who understand the possible value changes and the potential for losses as well as gains.

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    No Automatic Reinvestment

    A power feature of mutual funds is the ability to have dividends automatically reinvested into more shares of the fund. This compounding can help bond funds and stock funds focused on dividends to generate significant account growth. With an ETF, any dividends paid by the fund will be deposited in the investor's brokerage account as cash. To reinvest the dividends into the fund, the investor will pay another stock commission to buy the ETF shares. The ability to reinvest dividends gives index mutual funds an advantage over ETFs.Watching the exchange by rednuht 

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    No Account Building

    ETFs are not the right choice for investor's who want to build a portfolio with regular monthly investments. The commissions charged to buy ETF shares will reduce the amount actually invested and increase the time before the investor starts earning profits. An investor who wants to invest $100 or more every month could spend $100 on commissions alone during the year buying ETF shares. A no-load index mutual fund will allow the monthly investments without and sales charge or fees. One advantage of ETFs is this case is that an investor could buy just a few hundred to $1,000 dollars worth of a specific ETF. The minimum purchase could be just one ETF share. Many index mutual funds have initial investment requirements of $3,000 to $10,000. 

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    References

    Morningstar Article on Leveraged and Inverse ETFs: http://news.morningstar.com/articlenet/article.aspx?id=271892

    SEC on Leveraged and Inverse ETFs: http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm

    Photo Credit: rednuht on Flickr, Creative Commons Attribution