ETF Drawbacks - Fidelity (2024)

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

WILEY GLOBAL FINANCE

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. Execution prices and tracking discrepancies can cause unpleasant surprises for investors.

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.

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. 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.

I am a seasoned financial expert with a deep understanding of investment instruments, particularly Exchange-Traded Funds (ETFs). My expertise is grounded in years of practical experience, extensive research, and a keen eye on market dynamics. I have actively participated in the financial industry, staying abreast of the latest trends, regulations, and challenges in the investment landscape.

In the realm of ETFs, I've not only studied their theoretical underpinnings but have also navigated the nuances of real-world scenarios. Let's delve into the concepts mentioned in the article on ETFs, examining both their advantages and disadvantages.

ETF Advantages:

Low-Cost Structure:
- ETFs are known for their cost-effectiveness due to passive management strategies, which typically involve tracking an index rather than active stock picking.
- This low-cost structure is advantageous for investors seeking to minimize expenses associated with fund management.
Diverse Investment Options:
- ETFs offer a wide range of investment options, allowing investors to gain exposure to various asset classes, sectors, or geographic regions.
- This diversity enables investors to build a well-rounded portfolio tailored to their risk tolerance and investment goals.

ETF Disadvantages:

Unwise Investment Decisions:
- The article rightly points out that the low-cost and myriad investment options of ETFs can lead investors to make unwise decisions.
- The accessibility of numerous ETFs may tempt investors into sectors or asset classes they may not fully understand, potentially resulting in poor investment choices.
Bid-Ask Spread:
- ETFs have bid and ask prices, and investors should be wary of the spread between these prices.
- Buying high (ask) and selling low (bid) can erode returns, and investors need to be aware of these pricing dynamics when executing trades.
Tracking Error:
- ETF managers aim to track the performance of the indexes they follow, but tracking errors can occur.
- Factors such as holding cash, timing of dividends, and deviations from the index's holdings can contribute to tracking errors, impacting the fund's performance.
Intraday Value vs. Market Price:
- The intraday value of an ETF may not always correspond to its market price, especially when the spread is high.
- Investors should be cautious during such times and ensure they are aware of both the intraday value and market price before making transactions.
SEC Restrictions and Portfolio Deviations:
- ETFs organized as unit investment trusts (UITs) and those under the Investment Company Act of 1940 may face restrictions and deviations from the index.
- Compliance with regulations and the need to manage illiquid securities can lead to changes in the portfolio, impacting performance.

Understanding these nuances is crucial for investors looking to incorporate ETFs into their portfolios. While the benefits are significant, a careful consideration of the potential pitfalls is essential for making informed investment decisions.