The Dark Side of ETFs

Until now, I've been a big fan of exchange-traded funds (ETFs). After all, they offer choice, flexibility, low costs and tax efficiency, among other benefits. And they're growing like wildfire. But, there is a downside. Two dangers can threaten your ETF portfolio.

#1 - The Liquidity Factor: You Can Buy, But Can You Sell?

With so many new ETFs coming on market, there's a real concern that you may not be able to sell. Now there's no liquidity problem with most of the older, bigger ETFs, such as the DIAMONDS Trust (AMEX: DIA), which trades on average 8.4 million shares a day; the S&P Depository Receipts (AMEX: SPY), with daily volume reaching 87 million; or the NASDAQ 100 Trust (Nasdaq: QQQQ), which trades 128 million shares on average... But what about those ETFs that have zero (0) trades in a day?

And lots of other ETFs have serious liquidity problems too, trading fewer than 10,000 shares a day. Liquidity also depends on popularity, and while some new ETFs can be extremely popular when first introduced, it's also quite possible that some of these "hot" ETFs will be difficult to unload years later!

Best advice: Check the average daily volume of each ETF, and don't invest unless there is good liquidity in BOTH bull and bear markets.


#2 - Poor Diversification

The other threat to your wealth is an incomplete ETF index. That's not a problem with the S&P Depository Receipts, which mimic the S&P 500 Index; or the DIAMONDS Trust, which imitates the Dow 30. But some ETFs, like Merrill Lynch's Internet HOLDRs (AMEX: HHH), is heavily weighted in only three stocks.

Best advice: Check the holdings of an ETF before you invest.

In short, don't sell your mutual funds anytime soon. Ultimately, they may have some advantages over ETFs, especially when it comes time to sell or diversify.

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