Disadvantages of Trading ETFs : NobleTrading Blog

Monday, March 23, 2009

Disadvantages of Trading ETFs

Exchange Traded Funds (ETFs) have many advantages over other financial instruments. But they also have some disadvantages. The effect of these disadvantages on a trader’s portfolio can differ with trading goal, risk capital involved, portfolio diversification, trading style, market knowledge, ETF type, tracking index/sector, etc. Below are some major disadvantages of trading ETFs.

Trading costs – one of the major advantages of ETFs is that they are traded just like stocks, but stock trading involves brokerage fees so does ETF trading. This can significantly reduce the profit of an active ETF trader.
Underlying volatility – ETFs passively track other financial instruments, which can be liquid or volatile. Usually market indexes are less volatile than specific sectors or industries. Similarly international ETFs which track indexes of countries/regions with strong fundamentals are less volatile.
ETF liquidity – Although the liquidity of ETFs match liquidity of tracking index, their own trading volume is also a factor worth noticing. With coming of new types of ETFs to the market, now there are quite a few not-so-liquid ETFs having large differences between ask and bid prices.
Capital gains distribution – most ETF firms invest capital gains to the market, which is often the right thing to do. ETFs which distribute capital gains to ETF holders are making the shareholders qualify for capital gains tax.
Dollar Cost Averaging – DCA is a simple but effective way of building a big portfolio. But the costs involved in ETF trading makes DCA less-effective (unless trading through a discount broker).