4 Reasons ETFs Aren't as Cool as You Think

Keep an eye on fund costs, trading behavior, and taxes.

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With the hype surrounding exchange-traded funds that track anything from gold to small-cap Chinese stocks, it's no wonder investors think they're the greatest invention since sliced bread. ETFs are similar to index funds that invest in the holdings of a certain index or a basket of stocks, bonds, and commodities. The difference is that ETFs can be bought and sold on an exchange during the trading day. After studying ETFs over the last several years, we have found that the flexibility, transparency, low costs, and tax efficiency touted as benefits of ETFs are either offset by other costs or do not have meaningful benefits for investors. Here are a few reasons to give ETFs a second thought before you buy them:

1. Investors may not get the best price when trading ETFs. Unlike mutual funds, investors can buy and sell ETFs during the day and get whatever the price is at the moment the trade is executed. On the other hand, mutual funds are priced according to their net asset value (NAV), which is determined after the markets close. (NAV is the value of all of the portfolio's holdings, less liabilities, per share outstanding.)

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Fans of ETFs think being able to trade and get up-to-the-minute pricing gives investors more flexibility—and therefore more transparency—versus the end-of-day pricing for mutual funds. The truth is, investors may pay a premium when buying ETF shares, or above the NAV, or sell their shares cheaper, or below the NAV. That's because even though the price of an ETF is visible at one moment when a trade is placed, it could take time for the trade to be executed, depending on how liquid the market is for that fund. So investors have to wait until the trade is executed to see the actual purchase or sell price—and that price might change from the time they placed the order. Sure, investors can place a limit or stop-loss order to buy or sell shares in a certain price range, but even then, it's uncertain what the price will be when the trade is done. Price disparities are more common in newer and smaller ETFs, and ones that own bonds or smaller-cap stocks in markets that are not very liquid.

2. Trading ETFs can lead to higher transaction costs. Given that ETFs are like index funds, there is no stock selection required to operate them. The ETF owns the same holdings and weightings of the index it tracks. This can be done by a computer at a very low cost, so ETFs charge low operating expenses—another widely touted benefit of ETFs.

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However, operating expenses are not the only costs associated with owning ETFs. These funds are traded on exchanges, so they must be bought and sold through brokerages. Transaction costs at discount brokers for ETFs run the same as stocks, about $9 per trade. For the individual investor, these fees can add up, especially if they take advantage of the ability to trade during the day. These higher trading costs will offset the lower operating costs of ETFs.

3. Emotions can take over when trading ETFs. The ability to trade ETFs at various prices during the day benefits only day traders. Most individual investors shouldn't be jumping in and out of the market every day. In fact, long before ETFs became popular, studies showed that investors trade too much. After allowing for reasonable trading (such as the sort used for rebalancing a portfolio or raising cash for expenses), investors were found to trade so frequently that trading costs ate into their returns. ETFs' momentary price fluctuations may tempt investors to make emotionally driven trades they'd be better off without. The outlook for a sector rarely changes from one day to the next, so once you're confident that an investment fits into your asset allocation, you should stick to it.

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4. ETFs are not as tax-efficient as proclaimed. An investor who sells an ETF and profits from it incurs a capital gain that's taxed like any other capital gain. Plus, an ETF must buy and sell holdings when the index it tracks makes changes to its holdings. This can cause the ETF to incur capital gains that it must distribute to shareholders just as a mutual fund would. Sometimes an ETF will make capital gains distributions, while an index fund tracking the same index will not, making the ETF less tax efficient than the index mutual fund. In fact, Morningstar estimates that the iShares S&P 500 ETF (IVV) to be much less tax efficient than the Vanguard 500 fund (VFINX).

One last point: Large institutions and hedge funds can benefit from trading ETFs as part of their sophisticated trading strategies. However, the average individual investor is not equipped to put those strategies into action. Investors who dive into those waters are swimming with sharks, without the sharp teeth to protect themselves.

Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April, 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC registered investment adviser which provides mutual fund and asset allocation recommendations and research to stores in The Mutual Fund Store system.