For decades, mutual funds have offered professionals Portfolio Management, diversification, and convenience for investors who lack the time or means to trade their portfolios profitably. In recent years, a new class of mutual fund has emerged that offers many of the same benefits as traditional open-ended funds with a much greater liquidity. These funds, called exchange traded funds (ETFs), trade on public exchanges and can be bought and sold during market hours, just like stocks.
However, the growing popularity of these funds 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 points to remember
- Exchange-traded funds, commonly known by their acronym ETFs, have become increasingly popular investment vehicles for individuals and institutions.
- Although ETFs are often touted as inexpensive ways to gain 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 the fact that they are always preferable to a comparable mutual fund.
Leverage is always a good thing
A variant of ETFs can employ leverage in varying degrees to achieve returns that are, directly or inversely, proportionally superior to those of the underlying index, sector or group of securities on which they are based. Most of these funds are usually multiplied by a factor of up to three, which can amplify gains displayed by the underlying vehicles and provide huge and quick profits to investors. Of course, leverage works both ways, and those who bet badly can suffer big losses in the blink of an eye.
The costs of maintaining leveraged positions in these funds are also quite significant in some cases. Portfolio managers are required to buy positions when prices are high and sell when they are low, to rebalance their assets, which can significantly erode the returns posted by the fund over a relatively short period of time. However, perhaps most importantly, many leveraged funds just don’t publish returns in line with their leverage ratio over time periods longer than one day, due to the effect of composition returns that mathematically disrupt the fund’s ability to track its index or another reference.
There are ETFs for every index
Many investors think there is an ETF available for every index or sector there is, but that is not the case. There are many indices for securities or economic sectors in less developed countries and regions that do not have sector funds based on them (like the CNX Service sector or Mid-Cap Index in India). Also, ETFs don’t always buy all the stocks that make up an index or sector, especially if it’s made up of several thousand stocks, like the Wilshire 5000 Index. Funds that track indices like this often buy only a sample of all securities in the sector or index and use derivatives which can increase the returns displayed by the fund. In this way, the fund can closely track the performance of the index or benchmark in a cost-effective way.
ETFs only track indices
Another common misconception about ETFs is that they only track indices. ETFs can track sectors such as technology and healthcare, commodities such as immovable and precious metals, and currencies. Few asset types or industries today don’t have ETFs covering them in one form or another.
ETFs always have lower fees than mutual funds
ETFs can generally be bought and sold for the same type of commission who is charged for trading stocks or other securities. For this reason, they can be much cheaper to buy than open-end mutual funds as long as a significant amount is traded. For example, a $100,000 investment can be made in an ETF for a $10 commission online, while a load fund would charge 1 to 6% of the assets. ETFs aren’t good choices, however, for small periodic investments, like a $100 a month purchase average program, where the same commission should 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 made up of a collection of periodically reset portfolios of securities, there is more to the world of ETFs than SPDRS, Diamondsand QQQs (“cubes”). Actively managed ETFs have emerged 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 argue 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 must pay a 4 to 5% selling fees will be much less likely to liquidate their positions when the stock price goes down two weeks after the purchase that they could not have had if they had only had to pay a commission of $10 or $20 to their online account broker. Short-term transactions also negate the fiscal liquidity found in these vehicles.
Additionally, there are times when the net asset value of an ETF may differ by a few percentage points from its actual value the last price due to portfolio inefficiencies. There was also speculation that ETFs were used to manipulate the market, and this practice may have contributed to the market crash in 2008. Finally, some analysts believe that many ETFs do not provide adequate diversification by fund. Some funds tend to focus heavily on a small number of stocks or invest in a fairly narrow segment of stocks, such as biotechnology shares. Although these funds are useful in some cases, they should not be used by investors seeking broad market exposure.
The essential
ETFs offer a number of advantages over traditional mutual funds in many ways, such as liquidity, tax efficiency, and low fees and commissions. There is, however, a fair amount of misinformation circulating about these funds. They do not cover all indices and sectors, and there are some limits to their effectiveness and diversification. Their liquidity may also encourage short-term trading which may not be suitable for some investors.