Exchange traded funds--ETFs--have become very popular investment products. ETFs allow investors to trade a wide range of asset classes and sectors through funds that are bought and sold like any stock. ETFs are very useful products for many investment plans and strategies. These funds do have some disadvantages when compared to individual stocks and mutual funds.
Ease of Trading
One of the advantages of ETFs can easily turn into a big disadvantage. ETF shares can be purchased and sold with the click of a mouse button through an online stock brokerage account. Investors who do not have a defined investment plan can find themselves chasing the hot sectors covered by the different ETFs. CNN Money noted that the more investors trade ETFs, the more likely they are to lose money. The tendency is to buy the hot sector ETF just as it peaks and then be forced to sell at a loss to move into the next hot ETF.
No Automatic Reinvestment of Earnings
Mutual funds allow investors to automatically reinvest dividends and capital gains into more shares of the fund. This allows compounding and dollar-cost averaging in a mutual fund account. ETF dividends and capital gains are paid as cash into an investor's brokerage account. ETF investors must decide where to invest earned dividends and have to pay a commission to buy more ETF shares. Dividend reinvestment through mutual funds has no cost, even with funds that charge a sales load.
Commissions and Other Costs
Commission cost are listed by Morningstar, CNN Money and Seeking Alpha as a main disadvantage of exchange traded funds. Every purchase and sale of shares of an ETF will also cost the investor a commission. The cost to trade ETF shares is the same as for stocks, Most major online discount brokers charge $7 to $10 to buy or sell ETF shares. For the investor who wants make regular investments in small amounts like $100 or $200, the commission will cause a significant impact on the investment returns. ETFs also have annual expenses. The expense ratios of exchange traded funds are lower than actively managed mutual funds but higher than owning stocks directly.