Exchange-traded funds (ETFs) can be a great investment vehicle for small and large investors alike. These popular funds, which are similar to mutual funds but trade like stocks, have become a popular choice among investors looking to broaden the diversity of their portfolios without increasing the time and effort that they have to spend managing and allocating their investments.
ETFs represent ownership in a basket of stocks or bonds. The value of an ETF can appreciate if the underlying assets appreciate. In addition, investments that incur cash flow such as interest or dividends may automatically be reinvested into the fund. However, investors need to be aware of some disadvantages before jumping into the world of ETFs.
Key Takeaways
- Exchange-traded funds (ETFs) have become incredibly popular investments for both active and passive investors alike.
- While ETFs provide low-cost access to a variety of asset classes, industry sectors, and international markets, they do carry some unique risks.
- Understanding the particulars of ETF investing is important so that you are not caught off guard in case something happens.
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Commissions and Expenses
One of the biggest advantages ofETFs is that they trade like stocks. An ETF invests in a portfolio of separate companies, typically linked by a common sector or theme. Investors simply buy the ETF to reap the benefits of investing in that larger portfolio all at once.
As a result of the stock-like nature of ETFs, investors can buy and sell during market hours, as well as enter advanced orders on the purchase, such as limits and stops. Conversely, a typical mutual fund purchase is made after the market closes, once the net asset value of the fund is calculated.
Every time you buy or sell a stock, you might pay a commission. This is also the case when it comes to buying and selling ETFs. Depending on how often you trade an ETF, trading fees can quickly add up and reduce your investment’s performance.
No-load mutual funds, on the other hand, are sold without a commission or sales charge—making them relatively advantageous,in this regard, vs. ETFs. It is important to be aware of trading fees when comparing an investment in ETFs with a similar investment in a mutual fund.
Many online brokers today offer zero-commission trading in stocks and ETFs. Note, however, that you may still pay a hidden commission in the form of payment for order flow (PFOF). This controversial practice routes your orders to a specific counterparty rather than having the market compete for your order at the best price possible.
If you are deciding between similar ETFs and mutual funds, be aware of the different fee structures of each, including the trading fees that may be generated inside of actively managed ETFs. And remember, actively trading ETFs, as with stocks, can reduce your investment performance with commissions quickly piling up.
Every ETF will also come with an expense ratio. The expense ratio is a measure of what percentage of a fund’s total assets are required to cover various operating expenses each year. While this is not exactly the same as a fee that an investor pays to the fund, it has a similar effect: The higher the expense ratio, the lower the total returns will be for investors.
ETFs are known for having very low expense ratios relative to many other investment vehicles, but they are still a factor to consider, especially when comparing otherwise similar ETFs.
Underlying Fluctuations and Risks
ETFs, like mutual funds, are often lauded for the diversification that they offer investors. However, it is important to note that just because an ETF contains more than one underlying position doesn’t mean that it is immune to volatility.
The potential for large swings will mainly depend on the scope of the fund. An ETF that tracks a broad market index such as the S&P 500 is likely to be less volatile than an ETF that tracks a specific industry or sector, such as an oil services ETF.
Therefore, it is vital to be aware of the fund’s focus and what types of investments it includes. As ETFs have continued to grow increasingly specific along with the solidification and popularization of the industry, this has become even more of a concern.
In the case of international or global ETFs, the fundamentals of the country that the ETF is following are important, as is the creditworthiness of the currency in that country.
Economic and social instability will also play a huge role in determining the success of any ETF that invests in a particular country or region. These factors must be kept in mind when making decisions regarding the viability of an ETF.
The rule here is to know what the ETF is tracking and understand the underlying risks associated with it. Don’t be lulled into thinking that all ETFs are the same just because some offer low volatility.
Note
Tracking error measures how closely an index ETF tracks its benchmark index. Those with larger tracking errors may come with hidden risks.
Low Liquidity
A big factor in trading an ETF,a stock,or anything else that is traded publicly is liquidity. Liquidity means that when you buy something, there is enough trading interest that you will be able to get out of it relatively quickly without moving the price.
If an ETF is thinly traded, there can be problems getting out of the investment, depending on the size of your position relative to the average trading volume. The biggest sign of an illiquid investment is large spreads between the bid and the ask. You need to make sure that an ETF is liquid before buying it, and the best way to do this is to study the spreads and the market movements over a week or month.
The rule here is to make sure that the ETF in which you are interested does not have large spreads between the bid and ask prices. Tighter spreads equal greater liquidity, and that corresponds with less risk in entering and exiting your trades.
Capital Gains Distributions
In some cases, an ETF will distribute capital gains to shareholders. This is not always desirable for ETF holders, as shareholders are responsible for paying the capital gains tax. It is usually better if the fund retains the capital gains and invests them, rather than distributing them and creating a tax liability for the investor.
Investors will usually want to reinvest those capital gains distributions; to do this, they will need to go back to their brokers to buy more shares, which creates new fees.
Because different ETFs treat capital gains distributions in various ways, it can be a challenge for investors to stay apprised of the funds in which they take part. It’s also crucial for an investor to learn about how an ETF treats capital gains distributions before investing in that fund.
Lump Sum vs. Dollar-Cost Averaging
Say you have $5,000 or $10,000 to invest in an index ETF (such as the SPDR S&P 500 ETF (SPY) but are not sure how to invest: in a lump sum or by dollar-cost averaging. Due to the proliferation of no-fee ETFs, broker commissions are no longer as important a factor as they once were.
Lump-sum investing means that you can put your entire investment to work right away. This is great in a rising market, but perhaps not optimal if the market looks like it is peaking or is unusually volatile.
With dollar-cost averaging, you spread the $5,000 or $10,000 across equal monthly investments. This strategy works well if the market declines or is choppy, but it does have an opportunity cost if the market rises when only part of your money has been invested. And even small commissions can add up over multiple buy orders unless your brokerage does not charge commissions.
Leveraged ETFs
When it comes to risk considerations, many investors opt for ETFs because they feel that they are less risky than other modes of investment. We’ve already addressed the issues of volatility above, but it’s important to recognize that certain classes of ETFs are significantly riskier investments than others.
Leveraged ETFs are a good example. These ETFs tend to experience value decay as time goes on and due to daily resets. This can happen even as an underlying index is thriving. Many analysts caution investors against buying leveraged ETFs at all. Investors who do take this approach should watch their investments carefully and mind the risks.
Some ETFs are also inverse, in that they move in the opposite direction of their reference or benchmark. Leveraged inverse ETFs can return negative 2x or 3x the benchmark. Because of how they are structured, inverse ETFs decay in value over time.
ETFs vs. ETNs
Because they look similar on the page, ETFs and exchange-traded notes (ETNs) are often confused with each other. However, investors should remember that these are very different investment vehicles. ETNs may also have a stated strategy, track an underlying index of commodities or stocks, and require fees, among other features.
Nonetheless, ETNs tend to have a different set of risks from ETFs. ETNs face the risk of the solvency of an issuing company. If an issuing bank for an ETN defaults, or worse, declares bankruptcy, then investors are often out of luck. It’s a different risk from those associated with ETFs, and it’s something that investors eager to jump on board the ETF trend may not be aware of.
Reduced Taxable Income Flexibility
An investor who buys shares in a pool of different individual stocks has more flexibility than one who buys the same group of stocks in an ETF. One way that this disadvantages the ETF investor is in their ability to control tax-loss harvesting. If the price of a stock goes down, an investor can sell shares at a loss, thereby reducing total capital gains and taxable income to a certain extent.
Investors holding the same stock through an ETF don’t have the same luxury—the ETF determines when to adjust its portfolio, and the investor has to buy or sell an entire lot of stocks, rather than individual names.
ETF Premium (or Discount) to Underlying Value
Like stocks, the price of an ETF can sometimes be different from that ETF’s underlying value. This can lead to situations in which an investor might actually pay a premium above and beyond the cost of the underlying stocks or commodities in an ETF portfolio just to buy that ETF. This is uncommon and is typically corrected over time, but it’s important to recognize as a risk that one takes when buying or selling an ETF.
Check an ETF’s disparity against its net asset value (NAV) for irregularities. If it is consistently trading differently from its NAV in the market, something fishy may be going on.
Issues of Control
One of the same reasons why ETFs appeal to many investors also can be seen as a limitation of the industry. Investors typically do not have a say in the individual stocks in an ETF’s underlying index. This means that an investor looking to avoid a particular company or industry for a reason such as moral conflict does not have the same level of control as an investor focused on individual stocks.
An ETF investor does not have to take the time to select the individual stocks making up the portfolio; on the other hand, the investor cannot exclude stocks without eliminating their investment in the entire ETF.
ETF Performance Expectations
While it’s not a flaw in the same sense as some of the previously mentioned items, investors should go into ETF investing with an accurate idea of what to expect from the performance.
ETFs are most often linked to a benchmarking index, meaning that they are often not designed to outperform that index. Investors looking for this type of outperformance (which also, of course, carries added risks) should perhaps look to other opportunities.
What Is Exchange-Traded Fund (ETF) Liquidity?
Liquidity is an important consideration in exchange-traded fund (ETF) investing. ETFs have differing liquidity profiles for many reasons. Investing in an ETF with relatively low liquidity may cost you in terms of a wider bid-ask spread, reduced opportunity to trade profitably, and—in extreme cases—an inability to withdraw funds in certain situations like a big market crash.
Are ETFs Safer Than Stocks?
ETFs are baskets of stocks or securities, but although this means that they are generally well diversified, some ETFs invest in very risky sectors or employ higher-risk strategies, such as leverage. For example, a leveraged ETF that tracks commodity prices may well be more volatile and hence riskier than a stable blue chip.
What Is an ETF’s Tracking Error?
An ETF’s tracking error is the difference between its returns and those of its underlying benchmark index. Tracking errors are generally small, and the largest, widely held ETFs have minimal tracking errors.
Why Are Inverse and Leveraged ETFs Only Intended for Day Trading?
Inverse and leveraged ETFs often use derivatives contracts like options and short-term forwards to achieve their stated goals. These types of instruments have inherent time decay, and they tend to lose value over time as a result, regardless of what happens in the index or benchmark that the ETF tracks. As a result, these products are only intended for day traders or others with very short holding periods.
The Bottom Line
Now that you know the risks that come with ETFs, you can make better investment decisions. ETFs have seen spectacular growth in popularity, and in many cases, this popularity is well deserved. But like all good things, ETFs also have their drawbacks.
Making sound investment decisions requires knowing all of the facts about a particular investment vehicle, and ETFs are no different. Knowing the disadvantages will help steer you away from potential pitfalls and, if all goes well, toward tidy profits.
