The Potential Risks of Exchange-Traded Funds

Exchange-traded funds or ETFs are securities that trade on stock exchanges—similar to stocks—but are invested in a basket of underlying stocks, bonds or other securities—similar to mutual funds. Often ETFs are designed to track the performance of a specific index, market or sector. Much like index mutual funds or index funds, some ETFs will hold a basket of securities that are similar to the index, market or sector they are designed to track. For example, an ETF tracking the S&P 500 might hold each of the underlying 500 stocks. Unlike mutual funds, which are priced once a day after the market closes, ETFs trade like individual stocks, which means their price is continuously adjusted during the trading day. This not only gives the ETF owner the flexibility to trade the security intraday, but it also makes it easier to value an ETF portfolio in real time.

ETFs can be relatively simple, transparent, inexpensive and easily-traded securities. Their popularity has increased exponentially in recent years, with ETFs now available to track nearly every major market, sector and asset class. Because ETFs invest in a variety of underlying companies and securities, using ETFs can help investors achieve greater portfolio diversification with smaller portfolios and lower transaction costs. This easy diversification is especially helpful for investors without necessary funding to properly diversify by investing in the individual underlying securities. With a more modest portfolio, establishing a diverse portfolio of individual securities could also mean paying more in trading costs as a percentage of your account. These are all important considerations when deciding whether or not to invest in ETFs versus a personalized stock or bond portfolio.

Are ETFs Right for You?

Although ETFs might be a relatively low-cost way of diversifying your portfolio, it is important to understand some of their potential drawbacks:

  • ETFs consist of pooled assets and aren’t tailored to help investors reach their individual investment goals.
  • Investors might duplicate assets or categories by owning multiple ETFs that hold similar underlying securities, which may undermine diversification goals.
  • While many consider ETFs passive investments, managers of those ETFs might be actively trading their underlying securities. Further, without proper counselling, some ‘passive investors’ make emotional, active trades in times of uncertainty or high volatility.

Let’s examine these potential ETF risks in more detail, so you can avoid making costly investment mistakes.

Risk #1: ETFs Are Pooled Assets

The first step in investment planning should be to define your long-term investment goals, then establish an investment strategy to achieve those goals. ETFs are pooled assets and can serve a specific purpose within a portfolio, such as helping you diversify or gain exposure to some market or sector. But ETFs aren’t tailored to help you reach your individual financial goals.

While general goals like long-term growth or matching an index are common, other factors such as investment time horizon, life expectancy and income needs vary widely from person to person. Because ETFs are pooled assets, they often follow strict mandates such as investing in a specific sector, index or asset class. If your individual circumstances change, the ETF manager can’t alter the strategy to adjust your specific needs. Managers may also have limited ability to update an ETF’s investment style or asset allocation to take advantage of current market conditions.  

Another important determination to make is your portfolio’s optimal asset allocation—the mix of stocks, bonds and other securities. Some individual investors may not want to make this important portfolio decision as its implications can be drastic in the long term. By investing in an ETF, you are simply one anonymous member of the investing pool, and the fund manager will not be able to alter an ETF’s strategy when your individual circumstances or goals change. While an advisor may be able to alter your equity exposure by trading in or out of equity-focused ETFs, you can likely establish a more personalized approach by investing individual stocks, bonds and other securities.

When making decisions about your financial future, a strategy tailored to your individual situation is important. If you have roughly $500,000 or more, you can normally achieve sufficient portfolio diversification without incurring outsized relative costs by investing in individual stocks and other securities. This approach can help you achieve goal-oriented portfolio personalization—an area where many ETF strategies might fall short.

Risk # 2: Diversification Gone Wrong

When done correctly, diversification generally benefits investors, but sometimes, investors get it wrong. They think they are diversified because they own a certain number of ETFs, but this isn’t always the case. You could hold several ETFs with over 100 underlying securities in their portfolio. So owning 10 ETFs could mean potentially having a stake in over 1000 underlying securities. Owning so many holdings can make even matching the performance of the overall market difficult once fees are taken into account.

These ETFs could also hold duplicate underlying securities or make you inadvertently over concentrated in certain sectors or countries. Because ETF managers don’t necessarily communicate with each other, different ETF managers might hold the same securities, or one manager might sell a stock that another manager is buying. This added complexity and potential duplication can undermine the reason you purchased the funds in the first place.

While owning several ETFs may seem like an efficient way to diversify, it’s important to understand that owning multiple ETFs isn’t always the best strategy. Potential security overlap or contradictory transactions are just a couple of reasons why owning several ETFs might not result in better portfolio diversification.

Risk # 3: Passive Investing Fallacy

The passive investing fallacy is that it is easy to be a passive investor. The mythical passive investor is one who buys a fund or security and holds on for the long term. Also referred to as “set it and forget it.” Many people buy mutual funds or ETFs believing that doing so makes them passive investors, but this often isn’t the case. Owning a so-called passive investment doesn’t make you a passive investor.

To start, though you might purchase an ETF for the long-term, simply owning an ETF and holding it forever, doesn’t make you a passive investor. While some ETFs do track an index to replicate a certain market, other ETFs are also actively-managed—meaning they trade in and out of underlying securities based on the managers’ underlying forecasts. So, though you may not see trades happening within your account, your strategy and holdings are changing.

Further, though passive investing may seem easy, it is psychologically tough. Buying and holding an ETF or any other fund or security during periods of market volatility is difficult. According to DALBAR, Inc., the average holding period for all equity mutual funds is just four years.i True passive investing, however, involves owning and holding your investments for the long-term. While four years may seem like a long time, it’s relatively short compared to some retirees’ potential investment time horizon of 20 years or more.

Passive investing’s difficulty comes primarily from human psychology. Investors are often searching for the next best thing and may suffer from the fear of missing out—known as FOMO to younger generations. For example, you may buy some US equity ETF just to watch as the European equity ETF posts great returns. Many times, just as you finally give into our built-in impulses and to trade into the hotter ETF, you are just in time to catch its cooling off. When you trade based on market fluctuations, you make active decisions and become an active investor regardless of the security you’re trading. However, some investors mistakenly think simply buying ETFs makes them a passive investor.

While it may be easier to stay passive and disciplined during a rising market, it can be much harder during a downturn. Before trying to pursue a passive ETF investing strategy, you should consider how you might react in a bear market—a market drop of roughly 20% or more over an extended period of time. This part of the market cycle often tests investors’ self-restraint. Unless you have nerves of steel, it may be in your best interest to hire an investment adviser who can counsel you and help you stay on track to meet your long-term goals.

There Are Other Options

ETFs serve an important purpose in today’s investment landscape, but, like all investments, they also have their potential drawbacks. To learn more about Fisher Investments’ views on ETFs, other securities or our current market outlook, please contact us today or download one of our investing guides.

iSource: “Quantitative Analysis of Investor Behavior, 2018,” DALBAR, Inc., as of 4/6/2018.