- INVESTING
- ETFS
For decades, mutual funds have offered professional portfolio management, diversification, and convenience to investors who lack the time or means to trade their portfolios profitably. In the 1990s, a new breed of mutual funds appeared, offering many of the same advantages of traditional open-ended funds with much greater liquidity. These funds, known as exchange-traded funds (ETFs), trade on public exchanges and can be bought and sold during market hours, just as stocks can.
The rise in popularity of these funds, however, has also created a fair amount of misinformation about ETFs. This article examines some of the common misconceptions surrounding ETFs and how they work.
KEY TAKEAWAYS
- Exchange-traded funds, or ETFs, have become increasingly popular investment vehicles for individuals and institutions alike.
- While ETFs are often touted as low-cost ways to get exposure to passive index investing, not all ETFs have low management fees, and not all ETFs are passively managed.
- Other misconceptions include the breadth of ETF offerings, the use of leverage to multiply ETF returns, and that they are always preferable to a comparable mutual fund.
Leverage Is Always a Good Thing
Some ETFs employ leverage to achieve returns that, either directly or inversely, magnify the movements of the underlying index, sector, or group of securities that the fund is based on. Most of these funds are usually leveraged by a factor of up to three, which can amplify the gains posted by the underlying vehicles and provide huge, quick profits for investors. Of course, leverage works both ways, and those who bet wrong can sustain big losses in a hurry.
The costs of maintaining leveraged positions in these funds are also quite substantial in some cases. Portfolio managers are required to purchase positions when prices are high and sell when they are low, to rebalance their holdings, which can substantially erode the returns posted by the fund in a relatively short period of time. However, perhaps most importantly, many leveraged funds simply don't post returns that are in tune with their proportion of leverage over periods of time greater than one day, due to the effect of compounding returns that mathematically disrupts the fund's ability to follow its index or another benchmark.
There Are ETFs for Every Index
Many investors believe that there is an ETF available for every index or sector in existence, but this is not the case. There are many indexes for securities or economic sectors in emerging markets and regions that do not have any sector funds available for U.S. investors, such as the MSCI Indonesia SMID Cap Index or the Indian healthcare sector.
Furthermore, ETFs do not always purchase all of the securities that make up an index or sector, especially if it is comprised of several thousand securities, such as the Wilshire 5000 Index. Funds that follow indexes like this often only purchase a sampling of all of the securities in the sector or index and use derivatives that can augment the returns posted by the fund. In this manner, the fund can track the return of the index or benchmark closely in an economical way.
$9.9 trillion
The total assets of all ETFs worldwide, as of the third quarter of 2023.
ETFs Only Track Indexes
Another popular misconception about ETFs is that they only track indexes. ETFs can track sectors, such as technology and healthcare, commodities such as real estate and precious metals, and currencies. Today, few types of assets or sectors do not have an ETF covering them in some form.
ETFs Always Have Lower Fees Than Mutual Funds
ETFs typically can be purchased and sold for the same kind of commission that is charged for trading stocks or other securities. For this reason, they can be much cheaper to buy than open-ended mutual funds as long as a large amount is being traded. For example, a $100,000 investment may be made into an ETF for a $10 commission online, whereas a load fund would charge anywhere from 1 to 6% of assets. ETFs are not good choices, however, for small periodic investments, such as a $100 per month dollar-cost averaging program, where the same commission would have to be paid for each purchase. ETFs do not offer breakpoint sales like traditional load funds.
ETFs Are Always Passively Managed
Although many ETFs still resemble UITs, in that they are comprised of a set portfolio of securities that is periodically reset, the world of ETFs consists of more than just SPDRS, Diamonds, and QQQs ("Cubes"). Actively managed ETFs have made an appearance in recent years and will most likely continue to gain traction in the future.
Other Misconceptions and Limitations
Although the liquidity and efficiency of ETFs are attractive, critics maintain that they also undermine the traditional purpose of mutual funds as longer-term investments by allowing investors to trade them intraday like any other publicly traded security. Investors who have to pay a 4 to 5% sales charge will be much less likely to liquidate their positions when the share price declines two weeks after purchase than they might have if they only had to pay a $10 or $20 commission to their online broker. Short-term trading also negates the tax liquidity found in these vehicles.
Furthermore, there are times when the net asset value of an ETF can vary by a few percentage points from its actual closing price due to portfolio inefficiencies. Finally, some analysts feel that smaller ETFs do not provide adequate diversification on a per-fund basis. Some funds tend to focus heavily on a small number of stocks or else invest in a fairly narrow segment of securities, such as biotechnology stocks. Although these funds are useful in some instances, they should not be used by investors seeking broad exposure to the markets.
Is an ETF the Same as an Index Fund?
Many exchange-traded funds are also index funds, meaning that they are structured to track the assets and returns of a market index. However, not all ETFs are index funds, and not all index funds are ETFs. Like any other security, it is important to thoroughly research the prospectus of a fund before making an investment.
What's the Biggest Risk in ETFs?
The biggest risk for ETFs is market risk—the danger that the underlying index or sector may face an economic downturn. Although ETFs are more diversified than individual stocks, they are still vulnerable to market-wide movements.
Are ETFs Cheaper than Mutual Funds?
Historically, ETFs have had lower expenses than mutual funds due to the costs of active management. However, some ETFs do have relatively high expenses, especially those dealing with high leverage, or specialized assets such as cryptocurrency. Like all other investments, it is important to research an asset thoroughly before making an investment decision.
The Bottom Line
ETFs offer a number of advantages over traditional open-ended mutual funds in many respects, such as liquidity, tax efficiency, and low fees and commissions. There is, however, a fair amount of misinformation floating around about these funds. They do not cover every index and sector, and there are some limitations to their efficiency and diversification. Their liquidity can also encourage short-term trading that may not be appropriate for some investors.