Trading ETFs can work just as well in facilitating dumb moves as it does with smart moves.
Most investors would agree when we say that Exchange Traded Funds or ETFs started out as the most benign investment innovation that has come along in our lifetimes.
The problem is that ETFs work just as well in facilitating dumb moves as smart ones. And there are all sorts of dumb moves that ETFs can facilitate.
In fact, if you get an urge to invest in oil stocks, or gold stocks, or Swedish stocks, or windpower stocks, or any of hundreds of other stock groups and themes, you can act on that urge without doing any messy and time-consuming research on individual stocks—research that may give you pause and keep you from investing.
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Indeed, you can act on your urge within minutes, since ETFs also trade on stock exchanges. You can buy or sell them at any time when the exchange is open. (With conventional mutual funds, you can only buy or sell at the end of the day, at a price that reflects the value of the fund’s holdings at the close of trading.)
You can buy ETFs on margin, so your broker can provide instant financing for a portion of your purchase.
Many investors are seduced by the flexibility and low fees of ETFs, compared to conventional mutual funds. They overlook the fact that ETFs don’t add any value to the underlying investment. Nor do they improve your market timing. They simply make it cheaper and more convenient to buy or sell.
Many brokers and portfolio managers have built a business around trading ETFs. Their sales literature focuses on how easy it is to invest in classes of investments.
It’s a great marketing gimmick, but it subverts the prime advantage of ETFs, which is low cost.
By the time the ETF specialists add their fees and commissions, their clients are paying the equivalent of actively managed MERs to buy what amounts to a hodge-podge of index funds.
Liquidity and access to margin borrowing can come in handy, and low fees are better than high fees. But most successful investors owe much of their success to holding a diversified portfolio of well-established companies over a period of years if not decades.
ETFs are more likely to lead you away from that path than help you follow it.
Considerations when trading ETFs
Typically ETFs are more tax-friendly and cheaper than mutual funds, even though they may hold more or less the same stocks.
There are benefits to ETFs, which are similar to mutual funds but trade like stocks. This means that investors can buy or sell during normal trading hours. They can also put stops or limits on their investments. However, every time an ETF is bought or sold, you pay a commission. Many investors already know this process, which is the same as buying or selling stocks. But in the end, these commissions mean ETF investing can get costly if you make a lot of buys and sells.
5 considerations when trading ETFs
- ETFs can be volatile, even with the diversification they typically offer.
- Know how broadly diversified the fund is so you can determine its volatility. The broader the ETF, the less volatility in general it will have.
- Know the economic stability of countries when investing in international ETFs.
- Know the liquidity of ETFs you invest in.
- Consider buying ETFs in a lump sum, rather than a number of small amounts, to avoid higher brokerage fees.
What has your experience with trading ETFs been like? Have you found yourself over trading and racking up commission fees? Let us know in the comments.
Note: This article was originally published in 2007 and has been updated.