Ask Yourself These Questions Before Investing In An ETF

An ETF seems like the perfect balance between a stock and a mutual fund. This investment vehicle offers diversity, yet you can still buy and sell it like a stock. The flexibility is tough to resist, which is why ETFs are proliferating. Some ETFs keep it simple and invest only in an index, while others are more targeted. But the popularity of ETFs doesn't mean they are appropriate for you. Ask yourself these questions before you enter the world of ETFs:

How often do you plan to make trades?
When comparing ETFs to mutual funds, consider how often you plan to buy and sell. Those who follow the principles of dollar cost averaging, or investing small amounts over a certain time period, might not want to buy an ETF since your brokerage will charge you every time you buy. Over time, the cost of buying the ETF might outweigh the fees associated with a mutual fund. However, if you plan on buying and holding, an ETF might be less expensive than a mutual fund.

What about your tax liability?
If it walks like a duck and quacks like a duck … it still might not be a duck, at least not to the IRS. An ETF can be bought and sold like a stock, but the IRS will tax you based on what the ETF invests in, not the ETF itself. For that reason, you should get answers on how the ETF is taxed so there are no surprises. For example, depending on the underlying investment, you might have to pay a short-term capital gains tax, even if you plan on holding on to the fund for a while.

How diverse is the ETF, really?
ETFs spread the wealth among different investments, or at least that's what they were intended to do. However, some ETFs focus on specific sectors, investments or strategies. Can an ETF be diversified if it invests in similar products? No. However, if you find a specific sector promising, then a narrow ETF might be right for you, but don't expect true diversification.

What does the ETF invest in?
Some of the newer ETFs might be too trendy. Check their underlying investments to make sure the ETF is sticking to its stated strategy or that it is hedging its bets. If you don't understand the underlying investment, don't use the diversification of an ETF as an excuse to get in over your head.

All investments involve risk. While ETFs are being touted as Mutual Funds 2.0, they might not suit your tax needs or risk tolerance, which is why you should investigate the ETF and its underlying assets before you buy.