ETFs: How to Mitigate the Risks

As the famous final line of "Some Like It Hot" goes: nobody's perfect. That goes for exchange traded funds (ETFs), too. But the advantages of ETFs - intraday liquidity, transparency, lower fees - far outweigh their risks. And the risks they do have can be mitigated with some effort on the part of the investor:

• Fees: If you’re trading ETFs frequently, you run the risk of racking up broker’s fees that eat into your returns. To mitigate the impact of broker's fees, make sure you know what you're paying to trade in order to decide if it's worth it. [ETFs and Taxes.]
• They’re Not Always Cheap: As we stated above, ETFs are cheaper than mutual funds on average. Not all ETFs boast low expense ratios, so you can help yourself by doing your research before you buy to ensure you’re getting the best deal.
• Less Liquid Areas: ETFs that focus on esoteric sectors may not be as liquid as a fund that tracks the S&P 500. If you want to invest in one of these funds, be sure to use limit orders and keep your trades small in order to avoid moving the price of a low volume fund too much.
• Taxes: Some ETFs, particularly those that trade futures contracts, can trigger taxable events in the form of a K-1. Know which ETFs these are so you don’t get surprised when it’s tax time. Information about taxable events can be found in the prospectus, or through your tax advisor. [How Commodity ETFs Are Taxed.]
• Leveraged and Inverse ETFs: Leveraged and inverse funds are great tools…for the right investor. They’re not for everyone, and if you’re considering employing one of these funds to hedge your portfolio, understand them inside and out. [Our Guide to Leveraged and Inverse ETFs.]