The Cons of Exchange-Traded Funds

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The Cons of Exchange-Traded Funds

These new investment options have their limitations, too.

The arbitrage mechanism keeping prices in line with NAVs isn’t fail-safe

Heavily traded issues such as SPDRs, which track the S&P 500, and PowerShares QQQ (QQQ), which tracks the Nasdaq 100, should trade right around the value of their underlying securities. But there can be a difference between an ETF’s price and the net asset value of its portfolio, especially for those ETFs that aren’t traded frequently.

Moreover, it is not yet known how ETFs might behave in the face of a full-fledged market correction. It’s conceivable that investors wishing to sell ETFs in the midst of such an event would have to sell their shares at prices below that of the ETF’s net asset value.

You may have to pay a commission to buy an ETF

The expense advantage of ETFs may also prove to be more mirage than fact for most investors. That’s because you must pay commissions to buy and sell ETFs, whereas a no-load mutual fund can be bought directly from the fund company, or a no-transaction-fee fund from a brokerage, for no sales charge.

If you plan on making a single, lump-sum investment, then it may pay to choose an ETF. However, even assuming a low commission of $8 per trade, a single lump-sum investment of $10,000 in the iShares S&P 500 Index would need to be held for nearly two years to beat Vanguard 500 Index’s (VFINX) costs, assuming you purchased the Vanguard fund without a transaction fee.

ETFs’ low expenses are touted as one of their key benefits, but the fact remains that if, like most of us, you invest regular sums of money, you’ll actually end up costing yourself far more with an ETF than you would with many mutual funds. Also, for the same reason, investors who wish to trade frequently would be much better off from a cost perspective with a regular mutual fund than with an ETF.