Etfs: Good Or Bad Investment Choice?

are etfs bad investments

Exchange-traded funds (ETFs) have become increasingly popular in recent years, but they are not without their risks. ETFs are similar to mutual funds but trade like stocks, allowing investors to broaden the diversity of their portfolios without increasing the time spent on management. However, investors need to be aware of the potential drawbacks before investing. One of the main disadvantages is the fees and expenses associated with ETFs, including management and administrative fees, which can impact overall returns. ETFs also carry the risk of market volatility, with potential large swings depending on the scope of the fund. Other risks include capital gains distributions, liquidity issues, and the potential for over-diversification, which can impact an investor's ability to control their portfolio. While ETFs offer convenience and instant diversification, investors need to carefully consider the potential limitations and risks before investing.

Characteristics Values
Management and Administration Fees Management and administrative fees can add up to as much as 1% and can erode returns.
Liquidity ETFs with low liquidity can lead to investors selling the ETF for lower than the value of the underlying securities.
Tracking ETFs aim to track an index or underlying security rather than beat it, which may not be suitable for investors looking for higher returns.
Overdiversification ETFs that are passively managed and track an index can lead to over-diversification with too many stocks.
Tax Complexity ETFs are classified as trusts on tax returns, which can cause investors to pay more tax than required.
Capital Gains Distributions ETFs that distribute capital gains to shareholders create a tax liability for the investor.
Premium or Discount to Underlying Value The price of an ETF can sometimes differ from its underlying value, leading to investors paying a premium.
Lack of Control Investors typically do not have a say in the individual stocks in an ETF's underlying index, limiting their control.
Performance ETFs are often linked to a benchmarking index and are not designed to outperform it.

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Management and Administration Fees

Management and administrative fees are a significant downside of investing in ETFs. These fees, which can be as high as 1%, cover the management of investments, salaries, rent, and other expenses. While included in the unit price, they can eat into returns. Marketing costs incurred by ETF providers as they compete for market share can also add up. ETFs with high expense ratios pose a higher risk of returns slippage than those run with lower expenses.

ETFs also have a large bid/offer spread, and volumes can be quite low. For an investor looking to gain decent exposure to the market or a particular theme, entry into and exit from an ETF holding can significantly impact returns if several bid or offer layers are necessary to complete the transaction volume. This can lead to large gaps between expected and actual returns. Poor liquidity can also force an investor to sell an ETF for less than the value of the underlying securities, undermining the investment case for entering the trade. While market makers can provide liquidity for ETFs, the bid-offer spread can be a disadvantage here as well.

ETFs aim to track an index or underlying security rather than outperform it. This product is suitable for investors who are happy with a "set and forget" strategy but generates average performance (less fees). If an investor is looking for higher returns, investing in individual stocks is a better strategy. While there is a risk in picking stocks, investors need to balance that risk if they seek a larger reward.

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Liquidity and Market Risk

Liquidity is one of the most important features of ETFs. It refers to how easily shares can be bought and sold without significantly impacting the ETF's market price. A highly liquid ETF allows for swift transactions at prices that closely reflect the intrinsic value of the underlying assets. This ensures that investors can easily enter or exit positions without encountering significant price discrepancies or incurring high trading costs.

ETFs have two layers of liquidity: the liquidity of the underlying securities (primary market) and the available liquidity in the secondary market. While the factors that determine liquidity differ in the primary and secondary markets, both help ensure the orderly trading of ETFs.

Primary Market Liquidity

The primary market liquidity of an ETF is tied to the value of its underlying securities. ETFs have a flexible supply of shares, which can be "created" or "redeemed" to offset changes in demand. This process is aided by tapping into the liquidity of an ETF's underlying portfolio of securities.

A specific type of entity known as an "authorised participant" (AP) can change the supply of ETF shares available. The AP can offload a large basket of shares (redeem) or acquire a large basket of shares (create) directly from the ETF issuer. Typically, the AP is doing business in the primary market to meet supply and demand imbalances from the trading that happens in the secondary market.

Secondary Market Liquidity

The secondary market liquidity of an ETF is related to the value of the ETF shares traded. Most ETF orders are entered electronically and executed in the secondary market, where the bid/ask prices that market participants are willing to buy or sell ETF shares at are posted.

The secondary market liquidity is primarily determined by the volume of ETF shares traded. Other factors that influence it include the investment environment and the trading volume and bid-ask spread of the securities that make up the ETF.

Market Risk

The single biggest risk in ETFs is market risk. If the market that an ETF is tracking goes down, the benefits of the ETF structure, such as low costs and tax efficiency, will not help.

ETFs that invest in less liquid securities, such as real estate or assets from emerging markets, tend to have less liquidity.

ETFs can also be subject to liquidity risk. Investors face the risk that liquidity may not be higher than the liquidity of the underlying securities in all market conditions. Disruptions to ETF liquidity could occur due to trading halts in underlying securities, extreme volatility, or operational glitches at a market maker. This could lead to increased bid-ask spreads and higher costs for investors to exit the market.

In addition, the use of ETFs for liquidity management purposes by institutional investors might imply that investors are becoming more sensitive to the materialisation of liquidity risk. If investors were forced to liquidate ETF positions during stress periods, they could face unanticipated transaction costs in the form of higher-than-usual bid-ask spreads and discounts to net asset value (NAV).

While ETFs offer many benefits, such as low costs and diversification, it is important for investors to understand the risks involved, including liquidity and market risk. By doing so, investors can make more informed decisions and potentially avoid potential pitfalls.

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Capital Gains Tax

Exchange-traded funds (ETFs) are generally considered to be tax-efficient, but there is some nuance to this. ETFs are often compared favourably to mutual funds in this regard, as they tend not to distribute a lot of capital gains. This is because ETFs passively track the performance of an index, and so only rebalance their holdings when the underlying index changes its constituent stocks. Mutual funds, on the other hand, are more likely to be actively managed.

However, ETFs that hold dividend-paying stocks will distribute earnings to shareholders, usually once a year. Dividend-focused ETFs may do so more frequently. These dividends are taxed as ordinary income, up to a rate of 40.8%.

If you sell an ETF, any gains will be taxed based on how long you owned it and your income. If you sell an ETF that you've held for more than a year, you'll pay long-term capital gains taxes at a rate of up to 23.8%. If you hold the ETF for less than a year, you'll be taxed at the ordinary income rate.

There are some exceptions to the general tax rules for ETFs. ETFs that invest in commodities, currencies, and precious metals have different tax treatments. For example, ETFs that invest in commodities like oil, corn, or aluminium do so via futures contracts. These are taxed according to the 60/40 rule, which states that any gains or losses are treated as 60% long-term gains (up to a 23.8% tax rate) and 40% short-term gains (up to a 40.8% tax rate).

Precious metals ETFs, such as those backed by physical gold or silver, are structured as grantor trusts. The IRS treats these ETFs the same as an investment in the metal itself, which is considered an investment in a collectible. The maximum long-term capital gains rate on collectibles is 31.8%, and short-term gains are taxed as ordinary income.

Currency ETFs are usually in the form of grantor trusts, and profits from the trust create a tax liability for the ETF shareholder, taxed as ordinary income.

It's important to note that the tax treatment of ETFs may depend on the investor's jurisdiction, the structure of the ETF, and other factors.

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Active vs Passive Management

Exchange-traded funds (ETFs) are typically classified as passive investments. This means that they are designed to track the performance of a particular index, such as the S&P 500 or the ASX 200, rather than aiming to outperform it. While this can be a benefit to investors who are happy with average returns, those seeking higher returns may be better off investing in individual stocks or actively managed funds.

Actively managed funds, as the name suggests, involve a fund manager who actively selects and adjusts the fund's investments, with the aim of beating the market. Proponents of active management argue that this approach can lead to significantly higher returns over the long term, especially in less-researched areas of the market where inefficiencies exist. Additionally, active managers have the ability to sell out of positions before a market crash, potentially shielding investors from the full impact of a downturn.

However, it is important to note that active management does not guarantee higher returns, and there are additional costs associated with this approach. Actively managed funds typically charge higher fees to cover the cost of research, salaries, and other expenses. These fees can eat into investment returns, particularly for funds that are actively traded.

Another disadvantage of active management is that it requires investors to evaluate fund managers and choose those with a strong track record. This can be challenging, as past performance does not always predict future results.

In contrast, passive management offers a more hands-off approach, as the fund simply mirrors the performance of an index. This can be a more cost-effective strategy, as passive funds generally have lower fees than active funds. Additionally, passive funds provide instant diversification, as they invest in a broad range of stocks within a particular index.

However, the downside of passive management is that it may result in average or below-average returns, particularly in well-researched areas of the market like large-cap stocks. Passive funds also lack the flexibility to sell out of positions before a market crash, so investors are exposed to the full impact of any downturns.

In conclusion, the choice between active and passive management depends on an investor's goals, risk tolerance, and level of involvement. Active management may offer the potential for higher returns, but it comes with higher costs and the risk of underperformance. Passive management, on the other hand, provides a more passive approach with lower fees, but it may result in average returns and greater exposure to market downturns.

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Overdiversification

ETFs are often passively managed, meaning they track an index. This can lead to over-diversification, with the fund containing too many stocks. In this case, the investor may be better off buying individual stocks, as they have more control in selecting higher-quality stocks over lower-quality ones.

Actively managed funds, on the other hand, allow a fund manager to sell out of positions before capturing an entire market crash. Although not every active manager can do this, many can, making this perhaps the strongest argument for active fund management.

ETFs that track a broad market index, such as the S&P 500, are likely to be less volatile than an ETF that tracks a specific industry or sector, such as oil services. Therefore, it is vital to understand the fund's focus and what types of investments it includes.

ETFs have become increasingly specific, investing in niche parts of the market with themes such as climate change, cloud computing, clean energy, electric vehicles, fintech, semiconductors, blockchain, and digital currencies. These niche ETFs tend to produce very volatile returns and usually charge higher fees than broad-based ETFs.

Inverse ETFs, which seek to profit from falling stock markets, are among the worst offenders in terms of performance. Some of these ETFs have a further twist where the returns are magnified, whether positive or negative. For example, the BetaShares US Equities Strong Bear Hedge Fund aims to provide magnified returns opposite to the share market being tracked. Anyone who invested in this fund five years ago would have lost most of their money.

While ETFs can make investing easier for beginners and provide instant diversification for investors with limited funds, convenience always comes at a cost. For investors who don't need the convenience of an ETF, the limitations of ETF investing may make them better off not using them at all.

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