What You Want to Know Before Buying ETFs

In my previous post, I summarized the reasons I invested in ETFs (I currently have six PowerShares ETFs: PEY, PFM, PGJ, PHO, and PID), including

  • ETFs are priced as stocks;
  • Many ETFs are designed to track some popular indices;
  • The fees for sector ETFs are usually lower than their mutual fund counterparts;
  • ETFs can be purchased at any discount brokerage firm.

And my main concern is the cost (i.e., commissions for buying ETFs). Today, Sue Stevens at Morningstar offers a comprehensive list of Pros and Cons that every investor needs to know before buying ETFs.

Why you want to buy ETFs:

  • Tax efficiency: Distributions from ETFs usually happen less often than from traditional mutual funds.
  • Cost efficiency: Lower annual costs than even some index mutual funds.
  • Flexible trading: ETFs can be traded at any time of the day.
  • Various prices throughout the day: Since ETFs are priced as stocks, investors can purchase ETF shares at different price levels.
  • No minimum investment: You don’t have to have $1000, $2000, or $3000 in your account to buy ETFs.
  • Wide variety of asset classes: Just like sector mutual funds, there are ETFs covering every sector.
  • True global product: You can buy and sell ETFs any where in the world.
  • Style consistency: With sector-tracking ETFs, it’s possible to be more effective in maintaining your overall investment style with ETFs than with actively managed mutual funds.
  • Broad scope of investment options.

Why you should think twice before investing in ETFs:

  • Occasional unwanted distributions: Some ETFs do distribute capital gains (but mutual funds do as well).
  • Brokerage fees: By far, the biggest concern may be the commissions you have to pay for trading ETFs, unless you can find a firm that offers free trades (like Zecco?)
  • Bid/ask spread issues: Especially for low-volume ETFs, you may end up buying an ETF at a premium and selling at a discount (the same as stocks).
  • Liquidity, low trading volumes, settlement concerns: When you want to sell your ETF shares, there may not be a buyer right away.
  • May not replicate returns of underlying portfolio: Tracking error, management expenses, and the liquidity of the market the ETF targets may result in inferior performance.

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