Exchange-Traded Funds have become increasingly popular. But they’re imperfect if not used wisely.
Exchange-Traded Funds (ETFs) are the best thing since sliced bread these days. What started out as a somewhat niche financial product has become a mainstream investment vehicle for the masses.
For those unfamiliar with ETFs, they basically are a basket of either stocks or bonds, similar to a mutual fund, with the biggest difference being they trade on a stock exchange.
What made the ETF so popular?
#1 Cheap to own.
The biggest difference between an ETF and a traditional mutual fund was the price to own an ETF. Whereas you might pay a 2% management expense ratio (MER), ETFs offered much more reasonable MERs, sometimes saving an investor more than 50% in fees.
While small incremental percentages might seem like a minimal amount of money, over time, the difference staggering. Nerdwallet explains quite well here how 1% in fees could cost an investor more than $590,000 over 40 years of saving!
#2 Transparency of holdings.
The notoriety of mutual funds being an expensive investment vehicle to own gets even worse considering the disclosure rules when it comes to informing an investor what the mutual fund holds.
While it is mandated that mutual funds disclose their holdings on a quarterly basis, a lot can change in that 3 month period. Who knows – maybe the mutual fund manager is trading like crazy, eroding your returns while you sit at home, completely unaware.
ETFs on the other hand are required to disclose their holdings on daily basis. This means you can literally google your ETF and get a full list of what’s being held, immediately.
#3 Easy diversification
The rise of the ETF is also largely credited to the rise of the index fund, funds that track stock market indices, like the TSX, S&P 500, NASDAQ, etc. These ETFs became super popular as more and more data showed that passive investing beat active investing most of the time.
Instead of an investor buying an expensive mutual fund or losing money on trading commissions from building a portfolio of individual stocks, they could instead by an ETF and have access to the entire global market in one trade. This provides an investor low barriers to entry and exit when it comes to investing since a one or two fund solution could meet an investor’s needs.
So what’s wrong with the ETF?
As an index investor, I have no issues with using ETFs to generate a one to four fund solution for your investment needs. The problem that has emerged instead is the exponential growth of niche ETFs on the market. Let me explain.
#1 ETFs are becoming the opposite of simple, passive investing.
Health ETFs. Telecom ETFs. Bank ETFs. The world is your oyster when it comes to buying sector specific ETFs that it’s essentially overriding why ETFs were so popular in the first place.
A friend of mine recently to go buy a marijuana ETF, trying to capitalize on marijuana legalization happening in Canada. Did he make money? Nope. He lost a lot of it, because instead of treating the ETF as a simple investing solution, he went speculative, risking buckets of his hard earned cash. Similar to how stock picking is generally unwise unless you have time on your hands, speculative ETF buying is no different.
#2 Transparency is disappearing.
ETFs are getting so popular, the layers upon layers of what’s in a fund are hitting Inception levels: ETFs owning ETFs owning other ETFs – see what I’m getting at? Instead of an ETF owning basic publicly traded companies, a pattern of incestuous investing is emerging at an alarming rate.
If a key selling feature of the ETF was transparency, how is an investor to understand what’s in their ETF if all it’s holding are other ETFs? How deep down the rabbit hole of research does one have to go to actually determine the underlying assets of a fund?
#3 ETFs are causing overvaluations.
With the rise of passive investing, stocks are naturally becoming overvalued. This not a surprise: if millions of people chuck in money blindly into the market every month, they’re ignoring all the fundamentals and technical indicators. Stocks will track higher and higher because more money is flowing in with no regard on price.
This becomes problematic for all investors since we all know the higher you go, the farther you have to fall in a recession. While a recession is inevitable, investors will have to stomach even more drastic losses during a downturn – and we know how good investors are at that, don’t we?
So what’s an investor to do?
Keep it simple! By sticking to traditional index and bond ETFs, you can avoid all the trappings of niche ETFs, such as speculation and lack of transparency. ETFs are called passive investment vehicles for a reason: you’re supposed to buy a simple fund and hold. If you’re not doing that, then what’s the point?
My portfolio is made up of two foreign index mutual funds due to my desire to dollar-cost average with my paycheck every month. Bonds are held in two different funds across two different accounts.
- TD e-Series S&P 500 mutual fund
- TD e-series International Index mutual fund
- BMO ZAG Aggregate Bond Index
- Vanguard VAB Canadian Aggregate Bond Index