ETF Drawbacks: The Downsides of Investing in ETFs | Titan (2024)

ETFs are popular with investors of all backgrounds, but just because they’re popular doesn’t mean they’re perfect.

Whether you’re a veteran investor or are totally new to investing, you’ve probably come across the term exchange-traded fund, or ETF. An ETF is a basket of securities that trades on an exchange, just like an individual stock. ETFs are designed to track a specific index, sector, commodity, or other asset, while simultaneously providing increased diversification. Generally speaking, they are also lower-risk and lower-cost.

“ETFs are a way to invest and have market exposure,” says John DeYonker, Titan’s Head of Investor Relations. “And they’re incredibly cheap.”

As attractive as ETFs can be for a broad swathe of investors, there are also disadvantages to purchasing ETFs as opposed to other investment options. For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

Disadvantages of ETFs

Trading fees

Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ETFs are traded on the stock exchange like an individual stock, which means that investors may have to pay a real or virtual broker in order to facilitate the trade. These fees can range anywhere from $8–$30, and they’re paid every time an investor buys or sells shares in a fund. These fees can add up quickly and impact the performance of an ETF, especially if an investor buys small amounts of shares on a continuous basis. Some ETFs have no trading fees, but this depends on the ETF sponsor, as well as the brokerage or platform used to trade the fund.

Operating expenses

Although most ETFs are passively managed, fund managers still incur expenses as part of normal business operations. These costs are reflected in the fund’s expense ratio, which measures the percentage of an individual’s investment that will be paid to the fund each year. As of 2020, ETF expense ratios were usually less than 0.5%.

Although these expenses don’t work exactly like a fee, the effect is similar: A higher expense ratio lowers an investor’s total returns. The fee may cover employee salaries, custodial services, marketing costs, and the fund manager’s expertise in choosing and managing the underlying assets.

Low trading volume

When an ETF is actively managed, the higher number of trades within the fund may make the price of investing in the fund more predictable. High trading volume can also make the ETF more liquid, which can be beneficial. However, most ETF trading volume is low, which means that the bid-ask spread may be wider. Because of this, investors might not get the price they expect. Investors can check an ETF’s average trading volume before purchasing the fund to see whether it will meet their needs.

Tracking errors

Although an ETF manager will try to keep their fund’s investment performance aligned with the index it tracks, this may be easier said than done. An ETF can stray from its intended benchmarks for several reasons. For instance, if the fund manager needs to swap out assets in the fund or make other changes, the ETF may not exactly reflect the holdings of the index. As a result, the performance of the ETF may deviate from the performance of the index.

This can lead to tracking errors, or a difference between an investment portfolio’s return and the return of a chosen benchmark. That means an ETF could wind up costing more than its underlying assets, and an investor might actually pay a premium to purchase the ETF. Fortunately, this is fairly uncommon and typically corrects over time.

The possibility of less diversification

ETFs are known for offering a comparatively high level of diversification because they comprise hundreds — if not thousands — of securities within the market and across asset classes. Nevertheless, there are some ETFs that are more narrowly focused — for instance, they may focus on a particular sector of the market or a subset of an asset class. Some funds focus on large-cap or small-cap stocks, a particular country, a specific industry, or a particular commodity.

Hidden risks

With so many ETFs to choose from, the mix of assets in a single fund can be vast and complex. Some ETFs may contain riskier securities, but this might not be obvious to the investor. And just like any other kind of investment, ETFs are affected by the volatility of the market. That’s why prospective investors should research what the ETF is tracking so that they can understand the ETF’s underlying risks.

Lack of liquidity

Liquidity refers to how easily — or quickly — an investor can buy or sell a security in a secondary market. If an ETF trades at low volume or at high volatility, an investor may have a hard time selling it. You can get more information about an ETF’s liquidity by looking at its “bid-ask spread,” which is the difference between what an investor has paid for an ETF (the bid) and the price it can be sold for (the ask). Investments are typically considered illiquid when there’s a large spread between the bid price and the ask price.

Capital gains distributions

Some ETFs include dividend-paying stocks, which generate cash. On other occasions, an ETF might sell an asset at a profit that results in capital gains. The fund’s manager can distribute this money in two ways: pass the cash to the investors or reinvest it into the ETF’s underlying securities. Investors who receive cash but want to reinvest the money will need to buy more ETF shares, leading to new fees.

No matter the source of this cash or how the ETF chooses to use it, shareholders are responsible for paying associated taxes. Every ETF treats dividends and capital gains distributions differently, so investors will need to research the fund’s policy before choosing to invest.

Lower dividend yield

Some ETFs pay dividends, but investors may receive higher returns on specific securities, such as stocks with large dividends. That’s partly because ETFs track a broader market and therefore have lower yields on average. If an investor can take on the additional risk of owning individual stocks, they may receive higher dividends. If an investor is worried about managing individual stocks on their own, they may want to consider a Managed Stock strategy.

Less control over your individual investments

When you decide to invest in ETFs, you have less control over your investments because as an investor, you are not selecting the individual assets that make up the fund. Instead, a professional does this for you. If you’re looking to avoid investing in a particular company, industry, or type of asset, you might prefer a more hands-on investing approach.

ETFs are designed to track the market, not to beat it

ETFs are designed to track indexes, sectors, commodities, or other assets. But many ETFs track a benchmarking index, which means the fund often won’t outperform the underlying assets in the index. Investors who are looking to beat the market (potentially a riskier approach) may choose to look at other products and services.

What this means for you

Before investing in ETFs, it’s important to understand both their benefits and drawbacks in order to determine whether or not they’re the right choice for you. At Titan, we build strategies instead of ETFs, allowing you to own individual stocks (potentially generating higher returns) and better optimize for taxes. What’s more, we manage these investments for you, so you get all the benefits of ETFs minus many of their drawbacks.

ETF Drawbacks: The Downsides of Investing in ETFs | Titan (2024)

FAQs

ETF Drawbacks: The Downsides of Investing in ETFs | Titan? ›

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

What are the challenges of ETF? ›

  • Commissions and Expenses.
  • Underlying Fluctuations and Risks.
  • Low Liquidity.
  • Capital Gains Distributions.
  • Lump Sum vs. Dollar-Cost Averaging.
  • Leveraged ETFs.
  • ETFs vs. ETNs.
  • Reduced Taxable Income Flexibility.

Why are ETFs considered to be low risk investments? ›

Thanks to their lower costs and ability to diversify a portfolio, ETFs are considered low-risk investments. That's not to say ETFs are not risk-free. They can be tax-inefficient, generate high trading fees, and have low liquidity.

Is it bad to invest in too many ETFs? ›

Holding too many ETFs in your portfolio introduces inefficiencies that in the long term will have a detrimental impact on the risk/reward profile of your portfolio.

Why am I losing money with ETFs? ›

Interest rate changes are the primary culprit when bond exchange-traded funds (ETFs) lose value. As interest rates rise, the prices of existing bonds fall, which impacts the value of the ETFs holding these assets.

What is the primary disadvantage of an ETF? ›

Buying high and selling low

At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. Those are not good times to transact business.

What is the disadvantage of ETF over mutual fund? ›

Limited Capital Gains Tax

As passively managed portfolios, ETFs (and index mutual funds) tend to realize fewer capital gains than actively managed mutual funds. Mutual funds, on the other hand, are required to distribute capital gains to shareholders if the manager sells securities for a profit.

Has an ETF ever failed? ›

ETFs may close due to lack of investor interest or poor returns. For investors, the easiest way to exit an ETF investment is to sell it on the open market. Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF.

Is investing in ETF good or bad? ›

If you're looking for an easy solution to investing, ETFs can be an excellent choice. ETFs typically offer a diversified allocation to whatever you're investing in (stocks, bonds or both). You want to beat most investors, even the pros, with little effort.

Are ETFs riskier than funds? ›

Both are less risky than investing in individual stocks & bonds. ETFs and mutual funds both come with built-in diversification. One fund could include tens, hundreds, or even thousands of individual stocks or bonds in a single fund. So if 1 stock or bond is doing poorly, there's a chance that another is doing well.

Why are ETF high risk? ›

Market risk

The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.

Can an ETF lose all its value? ›

"Leveraged and inverse funds generally aren't meant to be held for longer than a day, and some types of leveraged and inverse ETFs tend to lose the majority of their value over time," Emily says.

Is it bad to hold ETF long term? ›

Nearly all leveraged ETFs come with a prominent warning in their prospectus: they are not designed for long-term holding. The combination of leverage, market volatility, and an unfavorable sequence of returns can lead to disastrous outcomes.

What is the 30 day rule on ETFs? ›

If you buy substantially identical security within 30 days before or after a sale at a loss, you are subject to the wash sale rule. This prevents you from claiming the loss at this time.

What happens if an ETF goes bust? ›

If you own ETF shares, you will receive cash equivalent to the value of your holding on the day of liquidation (not the value on the last day of trading).

Do ETFs go down in a recession? ›

ETFs. Investment funds are a strategic option during a recession because they have built-in diversification, minimizing volatility compared to individual stocks. However, the fees can get expensive for certain types of actively managed funds.

What is the biggest risk in ETF? ›

The single biggest risk in ETFs is market risk.

What is the primary disadvantage of an ETF quizlet? ›

What is the primary disadvantage of an ETF? Investors have to pay a broker commission each time they buy or sell shares. ETFs tend to have lower management fees than comparable index mutual bonds. ETFs usually have no minimum investment amount.

What is a disadvantage of an ETF quizlet? ›

The disadvantage is that ETFs must be purchased from brokers for a fee. Moreover, investors may incur a bid-ask spread when purchasing an ETF.

Why are ETFs riskier than mutual funds? ›

While these securities track a given index, using debt without shareholder equity makes leveraged and inverse ETFs risky investments over the long term due to leveraged returns and day-to-day market volatility. Mutual funds are strictly limited regarding the amount of leverage they can use.

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