The Hidden Risks and Costs of ETFs

Exchange-traded funds, or ETFs, are all the rage these days. There are thousands of them. According to the consulting firm PwC, ETFs now account for approximately $1.8 trillion in assets under management domestically. BlackRock is the industry leader, with almost $1 trillion in ETF assets. Other big players include Vanguard Group and State Street Corp.

ETFs and comparable index funds have a lot in common. Both invest in hundreds or thousands of stocks and bonds, permitting investors to obtain broad diversification through their purchase. Both are professionally managed.

There are also some meaningful differences. ETFs are traded on the major stock exchanges. The price of an ETF fluctuates during the course of a day. Mutual funds, including index funds, are priced once a day at the close of the market.

To purchase or sell an ETF, you need to open a brokerage account. Index funds can typically be purchased directly from the fund family.

Transaction costs are higher for ETFs than for index funds. You may have to pay a commission, and you will incur the cost of the "bid-ask spread," or the difference between the highest buyer's price and the lowest seller's price, whenever you buy or sell an ETF. When you buy, you will pay the ask price. When you sell, you will pay the bid price.

Some brokerage firms, for example, Charles Schwab, Vanguard and BlackRock's iShares business, offer programs with commission-free trades on certain ETFs. If you are relying on these programs, you should note that some firms limit commission-free transactions to only the ETFs they sponsor.

Index funds permit you to automatically reinvest dividends. There's no automatic investment option for ETFs. The minimum investment required for ETFs is generally lower than the typical minimum investment for index funds. You can buy an ETF for the cost of a single share. Index funds often have minimums starting at $1,000.

Used correctly, ETFs can be a valuable part of your portfolio. However, many investors are misusing them and suffering the consequences.

The initial problem with ETFs is that, as I mentioned previously, you need to open a brokerage account to buy or sell them. Most brokerage firms make more money selling you actively managed funds than they do selling you ETFs. Once you open an account, you can expect a barrage of sales pitches for all kinds of other, often dubious, products. Assuming you're able to resist the temptation to buy more products, you may still be lured into trading ETFs frequently based upon your broker's "research." This research will indicate that one sector is likely to outperform others. In my view, the fact that owning ETFs requires you to initiate a relationship with a broker is a compelling reason to avoid doing so.

Just because a fund is labeled as an ETF, doesn't mean it's not risky. There are a number of narrow ETFs, where the holdings are limited to particular countries and sectors. Buying these ETFs is a risky bet on the outperformance of that slice of the market.

There are also leveraged and inverse ETFs. Leveraged ETFs seek to return multiples of the performance of whatever index or benchmark they are tracking. Inverse ETFs, on the other hand, increase in value when the performance of the index or benchmark they track declines. Leverage and inverse ETFs track broad market indexes or currencies, commodities and sectors.

There are many problems with leveraged and inverse ETFs, including high risk, the chance that the fund will not meet its stated objective, high costs and less tax-efficiency than traditional ETFs. The U.S. Securities and Exchange Commission noted these additional risks for buy-and-hold investors in an alert.

John Bogle, founder of the Vanguard Group said he is concerned about the temptation to overtrade more narrow ETFs. He counsels investors to avoid altogether esoteric ETFs, such as leveraged and inverse ETFs, observing that's where the "fruitcakes, nut cases and lunatic fringe" can be found.

If you want to simplify your investments, consider low-cost exposure to the global stock market. Vanguard's Total World Stock Index Fund has an expense ratio of 0.30 percent. It is also available as a lower-cost ETF, Vanguard Total World Stock ETF, with an expense ratio of only 0.18 percent.

For the bond portion of your portfolio, consider exposure to both the domestic and international bond markets, such as the iShares Barclays Short Treasury Bond ETF and the SPDR Barclays Capital Short-Term International Treasury Bond ETF.

Now all you have to do is determine your allocation between stocks and bonds and rebalance periodically. Intelligent and responsible investing does not have to be complicated.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."