The Disadvantages of ETFs
Though the advantages of ETFs over other types of funds are appealing, there is a downside to exchange traded funds that an investor might not see or be looking for when considering an investment. Today's market for trading ETFs is increasing as more and more ETFs are being launched. This gives rise to some thinly traded markets with a low degree of liquidity, creating higher bid/ask spreads.
Profit prospects may be lower because of the high degree of diversification in a fund. They can also be lower in small sectors that are riskier with ETFs comprised of small groups of securities. If the price of one is reduced it has a greater affect on the price of the entire ETF increasing its volatility.
ETFs occasionally sell off holdings to bring the price of the fund closer to the market index or sector that it is supposed to be following. This rebalancing can produce unexpected capital gains or losses and unexpected taxes added to the fund's investors.
Buying and selling an individual stock that the investor knows carries the same commissions without the management fees of ETFs and higher profits can be taken if the investor can bear the higher risk.
Leveraged ETFs can be double or triple leveraged, which magnifies the gains significantly, but also does the same for losses.
The funds assets may not be there or allocated in an unexpected way. The underlying investment instrument may not be there due to buying on margin to attain a high degree of leverage. Physical commodities, such as metals, may be allocated in a way that could be unexpected (such as 80% allocated to gold) if an investor hasn't done his homework to find out this information.
Dividend yields can be lower in a traditional open-ended ETF than from an individual stock or a small group of stocks because they are averaged out in the fund which tracks a broad market. These returns are immediately reinvested in the fund and paid to all the investors monthly or quarterly.
ETFs are quite vulnerable to the vagaries of high frequency trading due to the fact that they have become increasingly popular with investors for electronic trading. When the "flash crash" of May 6, 2010 occurred, the DOW dropped 1,000 points in fifteen minutes. Many ETFs were hit quite hard as automatic stop-loss orders were activated.