Table of Contents
Disadvantages of ETFs
The bottom line
May 25, 2023
6 min read
Every ETF is different: Some come with fees or may lack diversification because they follow one type of asset.
(ETFs) are baskets of securities that trade on an exchange like a stock. They usually are designed to track an index, sector, commodity, or other asset, while providing diversification, limited risk, and low costs. “ETFs are effectively a way to invest and have market exposure,” says John DeYonker, Titan head of investor relations. “And they are incredibly cheap.”
However, there are disadvantages of ETFs. They come with fees, can stray from the value of their underlying asset, and (like any investment) come with risks. So it’s important for any investor to understand the downside of ETFs.
Disadvantages of ETFs
ETF trading comes with some drawbacks, which include the following:
Although ETFs generally have lower costs compared to some other investments, such as mutual funds, they’re not free. ETFs are traded on an exchange like a stock, so investors may have to pay a real or virtual broker to facilitate the trade. These fees typically range from $8 to $30, and they’re paid every time the investor buys or sells shares in a fund. These fees can quickly add up and reduce investment ETF performance, especially if an investor buys small amounts of shares on a continuous basis. Some ETFs come with no trading commissions, but it depends on the ETF sponsor and the brokerage or platform used to trade the fund.
Although most ETFs are passively managed, fund managers still incur expenses as part of normal business operations. These costs are reflected in the fund’s expense ratio, which measures the percentage of an individual’s investment that will be paid to the fund each year. As of 2020, ETF expense ratios were usually less than 0.5%.
Although these expenses don’t work exactly like a fee, the effect is similar: A higher expense ratio lowers an investor’s total returns. The fee may cover employee salaries, custodial services, marketing costs, and the fund manager’s expertise in choosing and managing the underlying assets.
Low trading volume
When an ETF is actively managed, the higher number of trades within the fund may make the price more predictable. High trading volume can also make the ETF more liquid, which can be beneficial. However, most ETF trading volume is low, so the bid-ask spread may be wider, meaning investors might not get the price they expected. Investors can check an ETF’s average trading volume before purchasing the fund to see whether it will meet their needs.
Although an ETF manager will try to keep their fund’s investment performance aligned with the index it tracks, that may be easier said than done. An ETF can stray from its intended benchmarks for several reasons. For instance, if the fund manager needs to swap out assets in the fund or make other changes, the ETF may not exactly reflect the holdings of the index. As a result, the performance of the ETF may deviate from the performance of the index.
This issue, along with others, can create tracking errors, or the difference between an investment portfolio’s return and the return of a chosen benchmark. That means an ETF could wind up costing more than the underlying assets, and an investor might actually pay a premium when buying that ETF. Fortunately, this is uncommon and is typically corrected over time.
Potentially less diversification
Many ETFs offer diversification because they contain hundreds or even thousands of securities within and across asset classes. But some ETFs are narrowly focused, concentrating on a particular sector of the market or a subset of an asset class. For instance, some funds focus on large-cap or small-cap stocks, a particular country, a specific industry, or a particular commodity.
With so many ETFs to choose from, the mix of assets in a single fund can be vast or complex—and some may contain risky securities that might not be so obvious upfront. Additionally, ETFs can be affected by volatility just like any investment. That’s why investors will need to research what the ETF is tracking and understand the underlying risks.
Lack of liquidity
refers to how easily or quickly an investor can buy or sell a security in a secondary market. An investor may have difficulties selling when the ETF is thinly traded, which means it trades at low volume and often high volatility. This can be seen in the difference between what an investor will pay for an ETF (the bid) and the price it can be sold for (the ask). This is known as the bid-ask spread. Investments are typically considered illiquid when there’s a large spread between the bid and ask.
Capital gains distributions
Some ETFs own dividend-paying stocks, which generate cash. On other occasions, an ETF might sell an asset at a profit that results in capital gains. The fund manager can distribute this money in two ways: pass the cash to the investors or reinvest it into the ETF’s underlying securities. Investors who receive cash but want to reinvest the money will need to buy more ETF shares, which creates new fees.
No matter how the ETF uses this cash or its source, shareholders are responsible for paying taxes. Every ETF treats dividends and capital gains distributions differently, so investors will need to research the fund’s policy before investing in it.
Lower dividend yield
Some ETFs pay dividends, but investors may receive higher returns on specific securities, such as stocks with large dividends. That’s partly because ETFs track a broader market and therefore have lower yields on average. If an investor can take on the additional risk of owning certain stocks, they may receive higher dividends.
Issues of control
ETF investing comes with less control because investors don’t select the individual assets in the fund. Instead, an expert does the work. However, individuals looking to avoid a particular company, sector, industry, or type of asset may prefer another investing strategy with a more hands-on approach.
Designed to track, not beat
ETFs are designed to track indexes, sectors, commodities, or other assets. But many track a benchmarking index, which means the fund often won’t outperform the underlying assets in the index. Investors who are looking to beat the market (which also carries risks) may choose to look at other products and services.
The bottom line
Before making a trade, investors should understand ETF drawbacks and consider whether the disadvantages outweigh the advantages. Every ETF is different: Some come with fees or may lack diversification because they follow one type of asset. Additionally, it’s always possible that an ETF will get out of whack with its benchmark. An investor can research an ETF upfront to understand any disadvantages and see if it fits their needs.
At Titan, we are value investors: we aim to manage our portfolios with a steady focus on fundamentals and an eye on massive long-term growth potential. Investing with Titan is easy, transparent, and effective.
Get started today.
Certain information contained in here has been obtained from third-party sources. While taken from sources believed to be reliable, Titan has not independently verified such information and makes no representations about the accuracy of the information or its appropriateness for a given situation. In addition, this content may include third-party advertisements; Titan has not reviewed such advertisements and does not endorse any advertising content contained therein.
This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Furthermore, this content is not directed at nor intended for use by any investors or prospective investors, and may not under any circumstances be relied upon when making a decision to invest in any strategy managed by Titan. Any investments referred to, or described are not representative of all investments in strategies managed by Titan, and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results.
Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. Please see Titan’s Legal Page for additional important information.
You might also like
What Are Inverse ETFs and How Do They Work?
An inverse ETF, often known as a bear or short ETF, is an exchange-traded fund designed to profit from a market decline.
ETF vs. Mutual Fund: What’s the Difference?
The main differences between the two lie in how they trade on securities markets and the tax liabilities they can create for investors.
What Are Clean Energy ETFs and How Can You Invest in Them?
Clean energy ETFs offer a diversified fund of stocks in the green energy sector. If you’re thinking of investing in clean energy ETFs, it’s important to know the upsides, downsides, and potential risks.
How Much Do ETFs Cost?
Although low costs are one of the advantages of exchange-traded funds, they still come with fees that reduce an investment’s overall return.
© Copyright 2023 Titan Global Capital Management USA LLC. All Rights Reserved.
Please refer to Titan's Program Brochure for important additional information. Certain investments are not suitable for all investors. Before investing, you should consider your investment objectives and any fees charged by Titan. The rate of return on investments can vary widely over time, especially for long term investments. Investment losses are possible, including the potential loss of all amounts invested, including principal. Brokerage services are provided to Titan Clients by Titan Global Technologies LLC and Apex Clearing Corporation, both registered broker-dealers and members of FINRA/SIPC. For more information, visit our disclosures page. You may check the background of these firms by visiting FINRA's BrokerCheck.
Various Registered Investment Company products (“Third Party Funds”) offered by third party fund families and investment companies are made available on the platform. Some of these Third Party Funds are offered through Titan Global Technologies LLC. Other Third Party Funds are offered to advisory clients by Titan. Before investing in such Third Party Funds you should consult the specific supplemental information available for each product. Please refer to Titan's Program Brochure for important additional information. Certain Third Party Funds that are available on Titan’s platform are interval funds. Investments in interval funds are highly speculative and subject to a lack of liquidity that is generally available in other types of investments. Actual investment return and principal value is likely to fluctuate and may depreciate in value when redeemed. Liquidity and distributions are not guaranteed, and are subject to availability at the discretion of the Third Party Fund.
The cash sweep program is made available in coordination with Apex Clearing Corporation through Titan Global Technologies LLC. Please visit www.titan.com/legal for applicable terms and conditions and important disclosures.
Cryptocurrency advisory services are provided by Titan. Cryptocurrency trading is provided by Bakkt Crypto Solutions LLC ("Bakkt Crypto"). Bakkt Crypto is not a registered broker-dealer or a member of SIPC or FINRA. Cryptocurrencies are not securities and are not FDIC or SIPC insured. Bakkt Crypto is licensed to engage in virtual currency business activity by the New York State Department of Financial Services. Cryptocurrency execution services are provided by Bakkt Crypto (NMLS ID 1828849) through a software licensing agreement between Bakkt Crypto and Titan. Please ensure that you fully understand the risks involved before trading: bakkt.com/disclosures.
Information provided by Titan Support is for informational and general educational purposes only and is not investment or financial advice.
Contact Titan at email@example.com. 508 LaGuardia Place NY, NY 10012.
As a seasoned financial expert with extensive knowledge in investment strategies and financial instruments, I can provide valuable insights into the content presented in the article "ETF Drawbacks: The Downsides of Investing in ETFs" published on May 25, 2023.
The article delves into the disadvantages of Exchange-Traded Funds (ETFs), a popular investment vehicle designed to track various market indices, sectors, commodities, or assets. Here's an in-depth breakdown of the concepts discussed:
- ETFs are subject to trading fees, which investors incur when buying or selling shares on an exchange. These fees can range from $8 to $30 per trade.
- Continuous small investments can accumulate fees and impact overall investment performance.
- Despite being passively managed, ETFs have operating expenses reflected in their expense ratio, typically below 0.5%.
- Higher expense ratios reduce investors' total returns by covering costs like employee salaries, custodial services, and marketing.
Low Trading Volume:
- Low trading volume in some ETFs can result in wider bid-ask spreads, making it challenging for investors to get the expected price.
- Actively managed ETFs with higher trading volumes may have more predictable prices.
- ETFs may deviate from their intended benchmarks due to changes made by fund managers, resulting in tracking errors.
- These errors create differences between the ETF's performance and the performance of the underlying index.
- While many ETFs offer diversification, some are narrowly focused on specific sectors or asset classes.
- Investors need to be cautious of potential concentration risks in narrowly focused ETFs.
- The complexity of assets within an ETF may include risky securities not immediately apparent.
- Volatility in the market can affect ETFs, and investors should thoroughly research the underlying assets.
Lack of Liquidity:
- Liquidity concerns arise when an ETF is thinly traded, impacting an investor's ability to buy or sell at desired prices.
- Illiquid ETFs may have a wide bid-ask spread, indicating potential difficulties in executing trades.
Capital Gains Distributions:
- ETFs distributing dividends or realizing capital gains may result in tax implications for investors.
- Investors should be aware of the fund's distribution policy and potential tax responsibilities.
Lower Dividend Yield:
- ETFs, tracking broad markets, may offer lower dividend yields compared to holding specific high-yield securities.
- Investors seeking higher dividends may consider individual securities.
Issues of Control:
- ETF investors relinquish control over individual asset selection, relying on fund managers' expertise.
- Investors preferring a hands-on approach may opt for other investment strategies.
Designed to Track, Not Beat:
- ETFs are designed to track specific benchmarks and may not outperform the underlying assets.
- Investors seeking market-beating returns may explore alternative investment products.
In conclusion, the article emphasizes the importance of investors understanding the drawbacks of ETFs before making investment decisions. Each ETF has its unique characteristics, and investors should carefully assess whether the disadvantages outweigh the advantages.