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Imperfections of Exchange Traded Funds

Exchange Traded Fund

In a previous article, we looked at reasons why exchange traded funds, or “ETFs”, might be suitable investments for individual investors. However, there are always two sides to a coin. In the Yin and Yang of investment analysis, we have to understand both the possible rewards and the risks involved. ETFs are not perfect investment instruments and these are just some of the things we need to be aware of.

Net Asset Value (NAV)

When we invest in the individual shares of all 30 companies in The Straits Times Index (SGX: ^STI), we can be quite certain we can cash out all our positions at any time and get back, roughly the same amount, the quoted market value for all the shares.

However, for ETFs, the price that they are trading at might differ significantly from the underlying value of all their holdings. That means to say that, even if the STI moves up, say, 10% from its current level of around 3,100 points, there’s a chance that ETFs that tracks it might not move up by the same amount.

It is also worth noting that this spread (the ratio between an ETF’s price and its NAV) might not stay constant. If you have invested in an ETF where the price has been equal to its net asset value, there is a chance the ratio (Quoted Price/NAV) might drop by the time you decide to sell it and any gain in value by the underlying shares that make up the ETF would thus not be able to be fully captured by you.

Liquidity

The main reason for the difference that might exist between the quoted price and the net asset value of an ETF is due to its liquidity.

When any particular ETF does not trade frequently, it might be hard for investors of the fund to extract its full value when they need to sell as there’s likely to be a lack of buyers. Thus, when choosing an ETF to invest in, finding one with high liquidity might be a safer bet.

Accessibility

Ironically though, if an ETF has high liquidity and if it is easy for an investor to get a quoted price constantly, it might be tempting to regularly trade on that ETF. That is the same reason why the Central Provident Fund (CPF) system works for some people as it forces them to save for the long term, with the money in the system typically being locked up for decades.

Purposeful inactivity is one of the requisite ingredients of long-term stock market success and any easy-accessibility of our money that’s invested in ETFs might thus challenge our willpower to truly hold it for the long run.

Foolish Bottom Line

ETFs, wonderful as they are as a financial innovation, have their weaknesses too as described above. There are even times when investing in ETFs can be considered dangerous.

All told, the way we shop for fresh produce like vegetables and fruits contains instructive lessons on how we should be making our investments; always look out for the best deals and make sure the product is not rotten inside.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.