ETF Drawbacks: The Downsides of Investing in ETFs

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.