While ETFs are generally less expensive compared to some other investments, such as mutual funds, they’re not free. But of course, no investment is perfect, and ETFs also have their downsides, ranging from low dividends to high bid-ask spreads. Identifying the pros and cons of ETFs can help investors identify the risks and opportunities and decide whether these securities make sense for their portfolios. Here are a few drawbacks of ETF investments.
Since ETFs are offered as a package of diversified investments rather than as a single stock, daily volatility is lower. Depending on your goals, this may or may not help your strategic direction. Low volatility means that your stock won’t rise by 20% on any given day, but it won’t rise by 20% either. You may have heard that the cost of ETFs is described as an advantage, not a disadvantage.
This is true in some contexts, for example when compared to investment funds. In fact, ETFs often have lower fees and costs, but as standalone products, ETFs aren’t free. Since these are not purely passive products, you must pay one (or more) fund managers to manage the stocks. Experienced traders can skip the fees associated with an ETF by managing stocks themselves.
The dividends of companies in an open ETF are reinvested immediately, whereas the exact time for reinvestment in index investment funds may vary. A lack of exposure to mid- and low-cap companies could mean that potential growth opportunities remain out of reach for ETF investors. However, if you have a small portfolio and want high diversification, ETFs that track major indices may be cheaper because you’re effectively able to own a portion of every company in that index and carry out an ETF transaction at the same time, rather than buying every single stock, which would be both costly and impractical. As with any investment, whether it’s stocks in a company, a mutual fund, or options, you need to thoroughly research ETFs before making long or short trades.
While they’ll stick to the parameters they set (you won’t get an ETF that tracks financial companies that suddenly start buying tech companies), they could start by replacing stocks you’d rather hold with stocks. As a result, using ETFs to achieve specific investment goals can be a challenge if the ETF tracks companies you don’t like. Some small-cap ETFs are broadly diversified and offer investors an index fund with selected companies.