Exploring the Downside of ETFs: A Comprehensive Guide

ETFs can be a great investment tool, but they're not without their downsides. One of the main issues with ETFs is their lack of transparency. This can make it difficult for investors to understand what they're actually buying.

Investors have reported instances where the underlying assets in an ETF didn't match the advertised holdings. This can be a major red flag. The Securities and Exchange Commission (SEC) has investigated several instances of ETF misrepresentation.

Many ETFs hold a small number of large holdings, which can lead to concentration risk. This means that if one or two of the underlying assets perform poorly, the entire ETF can be negatively impacted. In 2018, it was reported that some ETFs held as much as 90% of their assets in just a few stocks.

Concentration risk can be especially problematic for investors who are trying to diversify their portfolios. By spreading their investments across multiple asset classes, investors can reduce their risk. However, if their ETFs are concentrated in a few large holdings, they may not be getting the diversification they think they are.

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Disadvantages of ETFs can be a real challenge for investors. One major issue is that leveraged ETFs can lose more than double or triple the value change of the tracked index, making them a speculative investment that needs careful evaluation.

Trading costs can quickly eat into your returns, especially if you're not aware of an ETF's liquidity. Spreads can vary from one penny to many dollars, and can even change over time.

Leveraged ETFs don't always mean you'll see double the return of the index. In fact, the actual loss could multiply fast if held for a long time.

Trading costs can be a significant drawback of ETFs, as they can quickly eat into your returns. Understand an ETF's liquidity before you buy, and utilize limit orders to avoid trading around the open and close of the market.

Here's a comparison of the value changes of a double-leveraged ETF and the underlying index:

These examples show that double-leveraged ETFs don't always mean you'll see double the return of the index, and the actual loss could multiply fast if held for a long time.

You may have less control over your investments in an ETF, as the fund's goals may not match your own investment preferences, and you may end up with companies or sectors you don't want.

ETF investors may have limited choices compared to other investment vehicles, such as mutual funds, which can make it difficult to find an ETF that perfectly matches their investment needs.

A lack of diversification is another potential limitation of ETFs, as investors may be limited to large-cap stocks in certain sectors or foreign stocks due to a narrow group of equities in the market index.

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Limited diversification can be a significant investment limitation. In some sectors or foreign stocks, ETF investors might be limited to large-cap stocks due to a narrow group of equities in the market index.

This can leave out potential growth opportunities, such as mid- and small-cap companies, which are often overlooked by certain ETF investors.

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ETFs may not offer the range of options you need, with the number of available funds limited compared to other investment vehicles like mutual funds.

This limited choice can make it difficult to find an ETF that perfectly matches your investment goals.

In some cases, you may not be able to find an ETF that aligns with your specific investment needs, leaving you with a less-than-ideal investment option.

This can be frustrating, especially if you're looking for a specific type of investment or exposure to a particular sector.

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Tax and fees can be a significant downside of ETFs. You pay 28% tax no matter how long you hold gold bars, like in the SPDR Gold Shares ETF.

Higher fees can also offset your returns, especially if the ETF underperforms. Actively managed ETFs have an average expense ratio of 0.69%, according to ETF.com.

Tax consequences are unavoidable with ETFs, including rebalancing triggers that incur capital gains. The Global X FANG+ ETF rebalanced in 2021, resulting in a distribution of $2.14 per unit, significantly exceeding the previous year's distribution.

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Higher costs can eat into your investment returns, and it's essential to understand where these costs come from. Actively managed ETFs often have higher fees, with an average expense ratio of 0.69%.

These higher fees can offset your returns over time, especially if the ETF underperforms. It's crucial to weigh the potential benefits of active management against the increased costs.

The actual commission paid to the broker might be the same when trading ETFs, but there is no management fee for a stock. This means that investing in individual stocks can be a more cost-effective option.

Trading ETFs can result in a wide bid/ask spread, especially for niche ETFs that follow low-volume indexes. This can lead to higher costs and less favorable prices.

Commission costs of trading ETFs can add up over time, eating into investment returns. This is a concern for short-term traders who frequently buy and sell ETFs.

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Tax can be a major consideration when investing in ETFs. The tax consequences for ETFs are very different than investing in direct equities.

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You may think you're paying the favorable long-term capital gains tax rate, but that's not always the case. If you buy and sell an ETF like a stock, you're taxed based on what it holds, not what it's traded as.

For example, the SPDR Gold Shares ETF holds gold bars and is taxed as a collectible, meaning you pay 28% tax no matter how long you hold it.

Rebalancing triggers tax consequences in almost all circumstances, which can lead to hefty tax bills. This is the downside of ETFs that cannot be fixed by adjusting your behavior.

The Global X FANG+ ETF is a cautionary tale, where rebalancing led to a significant distribution of $2.14 per unit, far exceeding the previous year's distribution of 12 cents.

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A leveraged ETF can lose more than double or triple the value change of the tracked index, making it a highly speculative investment that needs careful evaluation.

Trading costs can quickly eat into your returns, with spreads varying from one penny to many dollars and liquidity issues affecting large trades.

Be aware of the "crowded trade risk", where money rushes into a new asset class, diminishing its attractiveness and potentially limiting liquidity.

ETFs can be traded throughout the day, but commission costs can add up over time, eating into investment returns.

Counterparty risk is a major concern for some ETF investors. ETNs, in particular, are vulnerable to counterparty risk because they're essentially unsecured debt notes backed by a bank that could go out of business.

Securities-lending programs within ETFs are generally safe, over-collateralized, and extremely secure. This is a stark contrast to ETNs, which leave investors exposed if the bank behind them fails.

Certain ETFs use financial instruments like futures contracts or swaps to gain exposure to specific assets, which introduces counterparty risk. This means the counterparty may not fulfill its obligations under the contract, putting investors at risk.

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Skewed Leveraged ETF Returns can be a major concern for investors. A leveraged ETF is a fund that uses financial derivatives and debt to amplify the returns of an underlying index.

Certain double or triple-leveraged ETFs can lose more than double or triple the value change of the tracked index. This means that if the ETF is held for a long time, the actual loss could multiply fast.

For instance, a 1% change in the price of natural gas should result in a 2% change in the ETF on a daily basis. However, if a leveraged ETF is held for greater than one day, the overall return from the ETF will vary significantly from the overall return on the underlying security.

Here's an example of how the value changes of a double-leveraged ETF vs. the index can vary:

A double-leveraged ETF does not always mean you will see double the return of the index. And the ease of investing in leveraged ETFs could entice individuals with little experience or understanding of the investment vehicle to invest when they should not.

Broken ETFs can be a major problem for investors. Most of the time, ETFs work just like they're supposed to, but sometimes something breaks and prices can get way out of whack.

The Athens Stock Exchange closed for over a month in the summer of 2015, and the Global X MSCI Greek ETF (GREK) traded at significant premiums to net asset value. This meant that if investors wanted to get out, they would expect to lose money when they sold.

ETFs can trade up to sharp premiums if the product has stopped issuing new shares, like in the case of commodity ETFs. If you buy an ETF trading at a significant premium, you should expect to lose money when you sell.

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Investors often flock to new and trendy assets, such as bank loans, which have seen over $12 billion invested in bank-loan ETFs.

This influx of money can actually decrease the attractiveness of the asset, making it a less valuable investment.

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ETFs can create new corners of the financial market, but some of these asset classes have limits on liquidity.

If the money rushes out, returns may suffer, making it essential to be aware of the risks involved.

It's essential to remember that just because an asset is trendy, it doesn't mean it should be a core part of your portfolio.

Even if an asset wasn't core to your portfolio a year ago, it should still be on the edge of your portfolio today.

To avoid being caught off guard, do your homework and stay informed about the potential risks of crowded trades.

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Market risk is the single biggest risk in ETFs, and it's not something you can control or mitigate no matter how cheap, tax efficient, or transparent an ETF is.

If the underlying assets, like the S&P 500, go down 50%, your ETF will follow suit. It's a harsh reality, but one to keep in mind.

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Trading an ETF can be costly, with spreads varying from one penny to many dollars. These costs can add up quickly and eat into your returns.

To minimize trading costs, understand an ETF's liquidity before buying and use limit orders. Avoid trading around the open and close of the market, as this can lead to wider spreads.

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ETF trading can be a bit tricky, especially when it comes to costs. Trading costs can quickly eat into your returns, so it's essential to understand an ETF's liquidity before buying.

Spreads can vary from one penny to many dollars, and they can change over time. You might face a small spread when buying a small amount, but a wider spread when selling a larger amount.

Trading costs can add up over time, which can eat into investment returns. This is especially true for short-term traders who buy and sell frequently.

Over-trading can be a poor decision, as a study found that individual investors who used ETFs underperformed those who didn't. The loss was around 2.3% a year, which is a significant difference.

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The problem is that the liquidity and low cost of ETFs can encourage investors to time the market. This can lead to buying ETFs at the wrong time rather than choosing the wrong ETFs.

Ultimately, investing in an ETF means you're taking the underlying investment decisions out of your hands. You're trusting the strategy or the professional fund manager to execute the mandate of the fund.

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Market risk is the single biggest risk in ETFs, and it's not unique to ETFs - mutual funds and closed-end funds face the same issue. If you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing can save you.

The value of an ETF can go up or down depending on the performance of the underlying assets, making market risk a major concern for investors.

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Exotic exposure can be a recipe for disaster if you're not careful. The US Oil ETF doesn't even track the price of crude oil, so if you think you're investing in oil, you might be mistaken.

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ETFs have opened up different areas of the market, but this increased access to complex strategies can be a double-edged sword. Not doing your homework can lead to big problems.

An average of 110 ETFs closed per year over the last 5 years, according to Bloomberg, so it's clear that some of these exotic ETFs aren't as popular as they once were.

The "hot new thing" in the world of ETFs can be tempting, but it's essential to approach with caution. A few years ago, most investors hadn't even heard of bank loans, but now more than $12 billion is invested in bank-loan ETFs.

Be wary of anything promising a free lunch, as these often come with hidden risks. The ETF marketing machine can be a mighty force, releasing new products almost daily.

Bank loans and emerging market debt are just a couple of examples of new asset classes that have gained popularity. However, some of these new asset classes have limits on liquidity, which can lead to reduced returns if the money rushes out.

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Study the marketing materials closely and work to fully understand the underlying index's strategy before investing. Don't trust any back-tested returns, as they may not reflect real-world performance.

If an investment wasn't core to your portfolio a year ago, it's probably still on the edge of your portfolio today. This is a good rule of thumb to follow when considering new investments.

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