Why Exchange-Traded Funds May Not Be Right for You

The Disadvantages of ETFs

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 disadvantages of ETFs will give you some added clarity on these investment vehicles, so you can better decide if they're a good fit for your investment style.

International Limitations

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While you can find an ETF to replicate just about any U.S. market sector, your options are less plentiful when it comes to foreign investments. International ETFs exist, but most emphasize large-cap companies across many different countries.

Your options for small-cap, country-specific ETFs are relatively limited compared to U.S.-based products. There's also a divide between large economies and small ones. You can find a small-cap ETF that's specific to China or the UK, for instance, but not for the Dominican Republic or Mali. Certain ETFs may contain exposure to Dominican or Malian economies, but they won't be exclusive to those countries, nor will they target specific areas of those economies.

Low Trading Volumes

Some ETFs are actively traded, but not all of them are. The advantage of purchasing an ETF over an index or equity diminishes when ETFs demonstrate low trading volumes—the bid-ask spread 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'll meet your needs as a trader.

Low Volatility Hampers Short-Term Traders

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 their goals, this may or may not help an investor’s strategic outlook. Low volatility is generally a good thing—your equity won't shoot up 20% on a given day, but it won't crash by 20%, either.

However, 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 some ETFs are designed for short-term plays, the vast majority of them aren't.

Some ETFs Contain Risky Products

ETFs come in all flavors. In many ways, that's a benefit—you can achieve nearly any investment goal through an ETF product. However, if you aren't carefully researching ETFs, you could end up inadvertently acquiring risky assets. For example, leveraged and inverse ETFs contain derivatives and other complicated securities, but a glance at the ETF's summary on a brokerage app might not clearly explain this.

When considering an ETF, closely examine its goals, underlying index, and holdings. Otherwise, you could end up buying an inverse S&P ETF when you meant to buy a regular S&P ETF (and the two are opposite investment products).

Costs

You may have heard the costs of ETFs referred to as a benefit, not a drawback. That's because ETFs usually come with lower fees and costs than their equivalent mutual funds. These fees are essentially payments to the fund managers for managing the holdings, so you can avoid fees altogether by picking stocks yourself. If avoiding fees is your primary goal, and you have the time to research individual stock opportunities, you're better off avoiding ETFs.

The Bottom Line

ETFs offer advantages to many investors, but they're far from a perfect investment product. There are downsides. For some investors, these downsides 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, considering the advantages of the strategy as well as the drawbacks.

If you've got 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 historical data to see how the ETF's performance compares to the index it tracks. When in doubt, consult a broker, a financial advisor, or another financial industry professional.

Article Sources

  1. Charles Schwab. "ETFs and Taxes: What You Need to Know." Accessed March 30, 2020.