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Problems With Exchange-Traded Funds

Exchange-traded funds (ETFs) have exploded in popularity over the years, but they also come with a number of potential drawbacks. Earlier this summer, the North American Securities Administrators Association (NASAA) expressed concern in an advisory notice that many investors may not fully understand the hidden risks associated with ETFs or how the investments actually work – until it’s too late.

“As with any investment, investors should know what they are investing in. They should understand the risks, costs and tax consequences before investing in ETFs. Check under the hood,” said NASAA President and North Carolina Deputy Securities Administrator David Massey in a June 27 ETF notice.

Exchange-traded funds started in 1993 when State Street sponsored the first ETF in the form of the SPDR Trust. The investments – which are designed to mimic the performance of an underlying index or sector – can be characterized as baskets of investments, and include stocks, bonds, commodities, currencies, options, swaps, futures contracts and other derivative instruments.

The problem is that all ETFs are not created equal. Some traditional ETFs may be appropriate for long-term investors, but other ETFs, such as exotic leveraged and inverse ETFs, may require daily monitoring, notes NASAA in its June ETF notice.

Other risks associated with some ETFs include liquidity. Does the value of the ETF equal that of its underlying securities? The number of ETFs that have been shut down or liquidated is up 500% in each of the last three years over 2007 levels. That comes to one ETF every week.

Huge fees are another issue investors need to be aware of when it comes to some exchange-traded funds. For example, leveraged and inverse ETFs must be traded all the time; that means you will pay a commission or fee each time a share is bought or sold.

The bottom line: The complexity, potential risks and substantial fees of exchange-traded funds may make them unsuitable investments for some investors.

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