Exchange-traded funds (ETFs) are baskets of securities that trade on an exchange like a stock. They usually are designed to track an index, sector, commodity, or other asset, while providing diversification, limited risk, and low costs. “ETFs are effectively a way to invest and have market exposure,” says John DeYonker, Titan head of investor relations. “And they are incredibly cheap.”
However, there are disadvantages of ETFs. They come with fees, can stray from the value of their underlying asset, and (like any investment) come with risks. So it’s important for any investor to understand the downside of ETFs.
Disadvantages of ETFs
ETF trading comes with some drawbacks, which include the following:
Although ETFs generally have lower costs compared to some other investments, such as mutual funds, they’re not free. ETFs are traded on an exchange like a stock, so investors may have to pay a real or virtual broker to facilitate the trade. These fees typically range from $8 to $30, and they’re paid every time the investor buys or sells shares in a fund. These fees can quickly add up and reduce investment ETF performance, especially if an investor buys small amounts of shares on a continuous basis. Some ETFs come with no trading commissions, but it depends on the ETF sponsor and the brokerage or platform used to trade the fund.
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 more predictable. High trading volume can also make the ETF more liquid, which can be beneficial. However, most ETF trading volume is low, so the bid-ask spread may be wider, meaning investors might not get the price they expected. Investors can check an ETF’s average trading volume before purchasing the fund to see whether it will meet their needs.
Although an ETF manager will try to keep their fund’s investment performance aligned with the index it tracks, that 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 issue, along with others, can create tracking errors, or the difference between an investment portfolio’s return and the return of a chosen benchmark. That means an ETF could wind up costing more than the underlying assets, and an investor might actually pay a premium when buying that ETF. Fortunately, this is uncommon and is typically corrected over time.
Potentially less diversification
Many ETFs offer diversification because they contain hundreds or even thousands of securities within and across asset classes. But some ETFs are narrowly focused, concentrating on a particular sector of the market or a subset of an asset class. For instance, some funds focus on large-cap or small-cap stocks, a particular country, a specific industry, or a particular commodity.
With so many ETFs to choose from, the mix of assets in a single fund can be vast or complex—and some may contain risky securities that might not be so obvious upfront. Additionally, ETFs can be affected by volatility just like any investment. That’s why investors will need to research what the ETF is tracking and understand the underlying risks.
Lack of liquidity
Liquidity refers to how easily or quickly an investor can buy or sell a security in a secondary market. An investor may have difficulties selling when the ETF is thinly traded, which means it trades at low volume and often high volatility. This can be seen in the difference between what an investor will pay for an ETF (the bid) and the price it can be sold for (the ask). This is known as the bid-ask spread. Investments are typically considered illiquid when there’s a large spread between the bid and ask.
Capital gains distributions
Some ETFs own 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 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, which creates new fees.
No matter how the ETF uses this cash or its source, shareholders are responsible for paying taxes. Every ETF treats dividends and capital gains distributions differently, so investors will need to research the fund’s policy before investing in it.
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 certain stocks, they may receive higher dividends.
Issues of control
ETF investing comes with less control because investors don’t select the individual assets in the fund. Instead, an expert does the work. However, individuals looking to avoid a particular company, sector, industry, or type of asset may prefer another investing strategy with a more hands-on approach.
Designed to track, not beat
ETFs are designed to track indexes, sectors, commodities, or other assets. But many 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 (which also carries risks) may choose to look at other products and services.
The bottom line
Before making a trade, investors should understand ETF drawbacks and consider whether the disadvantages outweigh the advantages. Every ETF is different: Some come with fees or may lack diversification because they follow one type of asset. Additionally, it’s always possible that an ETF will get out of whack with its benchmark. An investor can research an ETF upfront to understand any disadvantages and see if it fits their needs.