Since the early days of Exchange traded funds they have been the hit of Wall Street. Investors have, and continue to move their hard earned money from old school mutual funds to the new and exciting world of exchange traded funds. The ability to find diversity and liquidity matched with low or no fees has made ETF's a staple among almost every investor. While there are pages and pages we could write about the advantages of ETF's there is one common disadvantage that many inexperienced traders make. Today we will look closer at what is known as the "natural drag" of some ETF's and how to tell which ones are affected by this.First we ought to define the term "drag". Drag refers to the consistent difference between the returns of the ETF's benchmark and the ETF itself. Many ETF's will try to replicate a benchmark such as a market or commodity. When you review a quote for the (SPY  ) for instance and notice that it is up 2% you will also notice that the S&P 500 is also up 2%. In this case the ETF tracks almost perfectly with the benchmark. It can do this because it simply purchases the 500 companies in the S&P 500 and can hold the stocks free of charge for eternity. But what happens when you have an ETF that wants to track the price of Oil for instance? There is no particular stock for oil. Oil is a commodity and to trade it would require the purchase of Oil futures.

Futures have an expiration date just like options do. If one wanted to hold a future forever they would have to roll the future before every expiration. This is common, and their is nothing wrong with someone wanting to continuously roll a position until they achieve the desired result. The issue is cost. Each time you adjust the position before expiration there is a cost. A commission is charged and there may be a debit between the existing futures contract and the new contract. This also is paid by the trader. When an ETF company has to roll their futures positions to balance the ETF, those costs get passed on to the holders of the ETF. In addition, any fees that the company may incur also get passed on to the ETF holders.

To keep it simple, think of those "costs" as a deduction in the price of the ETF. It is for this reason that not all ETF's are best suited for long term positions. So let's leave you with an example. US Oil fund (USO  ) is one such ETF that has a drag. Again, this is because the fund has to purchase oil futures. Compare a chart of the commodity vs. the ETF and you will notice that the ETF will most always out pace the commodities decline. If you notice periods where oil trades sideways you will notice a small decline in USO.

To determine if the ETF that you may choose will have a natural drag and by how much, simply search the symbol on the company's website and read through the description of its objectives. If they use derivatives of any kind it will be stated there.