The drawbacks of ETFs

Be sure to look at both the advantages and disadvantages of ETFs.

  • Wiley Global Finance WILEY GLOBAL FINANCE
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While ETFs offer a number of benefits, the low-cost and myriad investment options available through ETFs can lead investors to make unwise decisions. In addition, not all ETFs are alike. Management fees, execution prices, and tracking discrepancies can cause unpleasant surprises for investors.

Trading costs

Depending where you trade, the cost to trade an ETF can be far more than the savings from management fees and tax efficiency. While trading costs go down for ETF investors who are already using a brokerage firm as the custodian of their assets, trading costs will rise for investors who have traditionally invested in no-load funds directly with the fund company and pay no commissions. Investors with a fund company cannot buy ETFs directly. They will have to open a brokerage account and pay a commission to buy shares.

If you plan on making a single, large, lump-sum investment, then paying one commission to buy ETF shares makes sense. But buying small amounts on a continuous basis may not make sense. For example, assuming an $8 per trade commission, a single lump-sum investment of $1,000 in the iShares S&P 500 Index (symbol: IVV) would cost 0.8 percent of the investment, or $8. Investing $1,000 every month would expose the investor to $96 in commissions over the course of a year. Staying with a no-load open-end fund is a better option under this scenario.

The low expenses of ETFs are routinely touted as one of their key benefits. But if you are like most people and invest regular sums of money, you actually may spend more on commissions than you would save on ETF management fees and taxes.

Finally, trading flexibility is a second double-edged sword. The ability to trade anytime and as much as you want are a benefit to busy investors and active traders, but that flexibility can entice some people to trade too much. High turnover of a portfolio increases its cost and reduces returns.

Buying high and selling low

ETFs have two prices, a bid and an ask. Investors should be aware of the spread between the price they will pay for shares (ask) and the price a share could be sold for (bid). In addition, it helps to know the intraday value of the fund when you are ready to execute a trade.

At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. Those are not good times to transact business. Make sure you know what an ETF’s current intraday value is as well as the market price of the shares before you buy.

Management fee creep

Not all ETFs are low cost. Prospective buyers should look carefully at the expense ratio of the specific ETF they are interested in. They may find the ETF of their choice is quite expensive relative to a traditional market index fund.
Before 2005, the expense ratio of all previously issued ETFs averaged 0.4 percent, according to Morningstar. Since 2005, the average expense of new funds has jumped to over 0.6 percent, and some new exchange-traded products are charging over 1.0 percent in fees. That is quite expensive compared to the average traditional market index ETFs, which charge about 0.20 percent.

Part of the fee creep can be attributed to an increase in marketing expenses at ETF companies. As the proliferation of ETFs continues, competition for funding is forcing companies to spend more money on marketing, and that cost is passed on to current shareholders in the form of higher fees.

Another cost creep factor is the cost to license indexes. Index licensing is a big business in the investment industry. Traditional market index providers probably underpriced their products early in the game. They are now making up for it by revamping their product lines and pushing fees higher. In addition, new, quantitatively manufactured index providers are pushing the upper bounds of licensing fees, and that drives ETF expense ratios higher still.

Tracking error

ETF managers are supposed to keep their funds’ investment performance in line with the indexes they track. That mission is not as easy as it sounds. There are many ways an ETF can stray from its intended index. That tracking error can be a cost to investors.

Indexes do not hold cash but ETFs do, so a certain amount of tracking error in an ETF is expected. Fund managers generally hold some cash in a fund to pay administrative expenses and management fees. In addition, the timing of dividends is difficult because stocks go ex-dividend one day and pay the dividend on some other day while the indexes’ providers assume the dividend is reinvested on the same day the company went ex-dividend. This is a special problem for ETFs that are organized as unit investment trusts (UITs), which, by law, cannot reinvest dividends in more securities and must hold the cash until a dividend is paid to UIT shareholders. Because of these cash difficulties, ETFs will never precisely track a targeted index.

ETFs that are organized as investment companies under the Investment Company Act of 1940 may deviate from the holdings of the index at the discretion of the fund manager. Some indexes hold illiquid securities that the fund manager cannot buy. In that case the fund manager will modify a portfolio by sampling liquid securities from an index that can be purchased. The idea is to create a portfolio that has the look and feel of the index and, it is hoped, perform like the index. Nonetheless, ETF managers who deviate from the securities in an index often see the performance of the fund deviate as well.

Several indexes hold one or two dominant positions that the ETF manager cannot replicate because of SEC restrictions on non-diversified funds. In an effort to create a more diversified sector ETF and avoid the problem of concentrated securities, some companies have targeted indexes that use an equal weighting methodology. Equal weighting solves the problem of concentrated positions, but it creates other problems, including higher portfolio turnover and increased costs.

Complexity and settlement dates

One disadvantage of investing in any exchange-traded portfolio is the added layer of complexity that comes with the products. Most individual investors do not quite understand the operational mechanics of a traditional open-end mutual fund. As such, it is a leap of faith to expect individual investors to easily comprehend the differences between exchange-traded funds, exchange-traded notes, unit investment trusts, and grantor trusts. These are not easy products to understand.

Another area of investor confusion is settlement periods. The settlement date is the day you must have the money on hand to pay for your purchase and the day you get cash for selling a fund. The ETF settlement date is 2 days after a trade is placed, whereas traditional open-end mutual funds settle the next day.

The difference in settlement periods can create problems and cost you money if you are not familiar with settlement procedures. For example, if you sell ETF shares and try to buy a traditional open-end mutual fund on the same day, you will find that your broker may not allow the trade. That is because there is a 1-day difference in settlement between the item sold and the item bought. If you try to make the trade, your account will be short of money for a couple of days, and at best you will be charged interest. At worst, the buy side of the trade will not occur.

Performance claims

One area that is neither an advantage nor a disadvantage of ETFs over traditional mutual funds is their expected returns. Some ETF companies increasingly try to set their products apart from traditional market index funds by inferring the indexes they follow will have better performance than the benchmarks.

There is no reason to believe that one ETF company’s products will outperform any other company’s products or the benchmark indexes. All fund companies choose securities from the same financial markets, and all funds are subject to traditional market risks and rewards based on the securities that make up their underlying value. As securities in a portfolio that makes up the ETF fluctuate, the value of ETF shares will also rise and fall on the exchange, as will the value of open-end mutual funds that are managed using the same strategy. Consequently, assuming the fee and investment objectives of a particular ETF and its competitors are the same, the expected return is also the same.

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