ETFs, or exchange traded funds, have surged in popularity over the past twenty years. An ETF is a basket of stocks that you can buy or sell through a brokerage firm on a stock exchange. ETFs can be thought of as mutual funds that can trade throughout the trading day instead of only at the end of the day (like mutual funds are restricted to.) ETFs are a wonderful way to invest in high-earning and expensive stocks without having to buy entire shares. You can buy ETFs in traditional assets like stocks, and even alternative assets like commodities or currencies.
Their popularity has led to specialized ETFs, like funds specialized in specific sectors such as energy or tech. A way for investors to get in on the action without as much commitment as a mutual fund, the market for this investment vehicle has grown tremendously. According to Fidelity, ETFs are estimated at $5.83 trillion with nearly 2,354 ETF products traded on U.S. stock exchanges in 2021.
One of the appeals of ETFs is how easy they are to trade — you can buy and sell any time of the day, which means that you can own portions of stock without holding the entire stock and still have the benefit of intraday trading. ETFs also typically generate a lower amount of capital gains comparable to mutual funds, as not all ETFs have to sell the underlying stocks in order to finance investments and, thus, expose their shareholders to capital gains.
While ETFs can provide investors with exposure to large baskets of securities without the commitment mutual funds might hold, experts overwhelmingly agree on the biggest two disadvantages to ETFs — they trade far too easily and lack necessary diversification.
Easy Trading Can Lead To Rookie Mistakes
The perceived ease which ETFs provide investors is also their Achilles’ heel.
Investors tend to like the idea of control, but that control can be precisely what leads to their downfall.
Robert R. Johnson, Professor of Finance at Creighton University and CFA, said, “The ability to trade at any time during the trading day can be a disadvantage to individual investors who may succumb to behavioral biases. That is, during volatile times in the market, investors may decide to liquidate positions in ETFs when markets have fallen, particularly when specific events occur during the trading day.” Behavioral biases see investors reacting emotionally to news or trading spikes and dips, then becoming rattled (or excited) and trading. This kind of trading can be exciting, but almost never benefits investors, particularly if they are not doing it professionally. “The liquidity of ETFs may encourage individuals to become traders rather than long-term investors. This may lead people to buy high and sell low.”
Attorney and financial expert Lyle Solomon added that since ETFs trade like stocks, their commissions mimic stocks’ as well; “ETFs trade like stocks. And just like stock trading, you have to pay a commission on them. Every time you buy and sell ETFs, you have to pay commission, which can lower your investment’s profits.”
Derek Horstmeyer, Professor at George Mason University School of Business whose research specializes in ETFs, highlights that the downside to the funds “is that because they trade continuously throughout the day, this encourages investors to trade too frequently. This leads to excess fees, short term capital gains and losses due to trying to time the market.”
The Overall Kicker: Lack of Diversification
Perhaps even more impactful, and certainly the gripe almost each of our experts shared, was the disadvantage of lacking portfolio diversification.
Investors are often attracted to ETFs that track an index, like the S&P 500. One major drawback is that these types of ETFs are rarely as diversified as one might think. Johnson explained, “ETFs that track a particular index don’t rebalance. The implication of not rebalancing is that one can end up with a highly concentrated portfolio if the underlying index is highly concentrated. It would seem that the S&P 500 is an extremely broad index. But the FAANGM stocks (Facebook, Apple, Amazon, Netflix, Google and Microsoft) account for 24% of the index, and that percentage has increased dramatically as the technology-oriented stocks have outpaced the market.”
This means that although you might believe you are investing in a diversified portfolio as it is tied to the S&P 500, you are not necessarily investing in 500 different stocks. “For example, in 2013, these six companies accounted for only 7% of the S&P 500. Thus, investors in many ETFs can find that they hold highly concentrated portfolios.”
The cardinal rule of investing is diversification, which can see ETF investing one-sided and expensive for no reason.
Ariel Acuna, founder of LTG Capital added, “As of recently, five stocks: Alphabet, Apple, Amazon, Facebook, and Microsoft accounted for about 25% of the S&P 500 and approximately 40% of the NASDAQ. If someone is buying ETFs like IVV, SPY or QQQ, are they truly diversified? I don’t think so. At least not like before the advent of these mega-cap tech stocks.”
SPY and QQQ are two of the most popular — and largest — ETFs, holding $412 and $202 billion respectively in assets under management.
Maximo Centeno, CEO and President of the Simple Group in Danbury, CT, advises that ETFs provide little “diversification because they mirror a particular index or market sector. When we thoroughly analyze the pricing structure of ETFs, we will realize that the costs are higher because you pay management fees as well as broker commissions.”
Investment advisor and VP of Operations with Lake Advisory Group Josh Simpson explained that “anytime you buy and sell an ETF, there is going to be a fee or commission that is charged, just like when you buy or sell a stock. If you trade often, then those extra fees and commissions could really add up over the long run.”
Any time the fund manager buys and sells a stock within the fund, another fee or commission is generated, just like there would be if you were buying and selling individual stocks on your own. Those don’t always have to be disclosed, but all those fees can eat into the return of the fund, Johnson added. Another important thing to keep in mind — taxes. “When it comes time to address capital gains at the end of the year some ETFs, not all, will distribute those gains to their shareholders,” he continued. “If you are not aware of this or prepared for it, it could have a significant impact on your taxes when you go to file. Because of this, ETF holders can lose control of the tax efficiency of their investments. Being responsible for capital gains you were not aware of can prevent you from being able to take enough losses to offset those gains.”
ETFs can be a great way to get involved in investing and cover a swath of assets you ordinarily might not be able to fully invest in, but they come with complications that should not be overlooked. Despite its hot status, its important to take into account the risks and overweighting that often comes when investing in ETFs before you make the commitment.
More From GOBankingRates