If you've done much trading, you've probably heard about the perks of exchange-traded funds (ETFs). While ETFs do offer tax advantages and other benefits, it's important to remember that, like any investment, they also come with disadvantages.
The following factors will give you some added clarity, so you can better decide for yourself whether they are downsides and whether ETFs are a good fit for your goals and investment style.
While you can find an ETF to replicate just about any U.S. market sector, your options are slim when it comes to foreign investments. International ETFs do exist, but not in the way you may be used to seeing them in the U.S. You'll have fewer options and less control over the particular assets, such as if you are used to dealing in ETFs from a single industry or sector.
Most foreign ETFs consist mainly of large-cap companies spread across many countries. Your options for small-cap ETFs specific to a single country are relatively limited compared to those based in the U.S. There is also a divide between large economies and small ones. You can find a small-cap ETF specific to China or the UK, for instance, but this task will be much tougher (or perhaps impossible) for places like Malta or Mali. Certain ETFs may contain some exposure to small or emerging economies, but they won't necessarily be exclusive to those countries, nor will they necessarily target specific geographic areas or sectors.
Low Trading Volumes
Some ETFs are actively traded. The appeal of buying an ETF over an index or other type of equity lessens when you look at trading volume, which is simply the amount of shares that change hands in a certain amount of time. It is an important metric because if there are a large number of people looking to buy or sell an asset, the large quantity of asks and bids will have a leveling effect on the price, which might be more predictable. For the same reason, high trading volume can make an asset more liquid. Large index ETFs can trade at a high volume, but most ETFs are quite light in trading volume. For some investors, the bid-ask spread of a low-volume ETF can be too wide to be cost-effective.
Before adding an ETF to your portfolio, take a look at the average trading volume, and see whether it will meet your needs as a trader.
You might be asking yourself: Isn't low volatility a good thing? For assets you expect to keep for the long term, the answer is probably yes. Assets that remain mostly stable will tend to rise as the market does: at a slow and steady pace. But for short-term trades, an asset with low volatility isn't that exciting. You're not likely to make much money by turning over a barely moving asset super quickly.
Since ETFs come as a package of diversified holdings rather than a single stock, there's less volatility on a day-to-day basis. Depending on your goals, that may or may not help your strategic outlook. Low volatility means that your equity won't shoot up 20% on a given day, but it won't crash by 20%, either.
Some traders want volatility because they specialize in short-term plays. They want to get in, enjoy quick movement, then get out once they've hit their profit target. While there are types of ETFs that cater to short-term plays, most are not designed that way.
ETFs come in all flavors. In many ways, that is positive; you can achieve nearly any investment goal through ETFs. The catch is that since there are so many ways to make up an ETF, lists of assets can be lengthy or complex. Some ETFs contain risky components that might not be obvious up front. If you don't conduct careful research on the ETFs you choose, you could end up acquiring assets you were not aware of. For example, leveraged and inverse ETFs contain derivatives and other complex securities. If you are only using a simple brokerage app, the full scope of details might not show up on an ETF's summary page.
When choosing an ETF, look closely at its goals, underlying index, and holdings. If you skip over even the smallest detail, you could end up with a surprise, such as an inverse S&P ETF when you meant to buy a regular S&P ETF (and the two are opposite products).
Fees and Costs
You may have heard the costs of ETFs referred to as a benefit, not a drawback. That is true in some contexts, such as when compared to mutual funds. Indeed, ETFs often have lower fees and costs, but as standalone products, ETFs are not free. Since they are not purely passive products, you will have to pay a fund manager (or many) to manage the holdings. Savvy traders can skip the fees that come with an ETF by managing stocks on their own.
If you have the time and smarts to make trades without a fund manager and are willing to do the research, you may prefer to avoid ETFs.
The Bottom Line
ETFs offer perks to many investors, but they're far from perfect. There are disadvantages. For some investors, these may outweigh the advantages, while others will decide that ETF investing is the way to go.
As with any investment—whether it's a company's stock, a mutual fund, or options—you need to thoroughly research ETFs before making any trades, either long or short. Conduct your due diligence, and weigh the advantages of your strategy as well as the drawbacks.
If you have an ETF in mind, watch it for a while to see how it reacts to different market conditions. Take a look under the hood to see what holdings the ETF would add to your portfolio. Dig through past data to see how the ETF performs against the index it tracks. When in doubt, consult a broker, a financial advisor, or another financial professional.