Pitfalls of investing in ETFs

By Doreenn Leong

Fears of a resurgence of coronavirus are spooking investors globally. China and Germany have reimposed some lockdown measures in places where new cases emerge.

The effect of the concerns over rising coronavirus cases was visible on Wall Street, where the Dow Jones Industrials Average index lost 0.7% and the S&P 500 declined 0.4% last week.

However, the benchmark FTSE Bursa Malaysia KL Composite Index (FBM KLCI) ended 2.35 points higher at 1,507.26, signalling a strong rebound of about 23% from the multi-year low of 1,219.17 on March 19.

Against this backdrop of uncertainties, what else can investors look at? Exchange-traded funds (ETFs) are an option, especially those that can gain from the rising trend of the outbreak.

ETFs have become tremendously popular because they allow investors to quickly own a diversified set of securities, such as stocks, at a low cost. They also allow investors to get very specific exposure to areas of the market, such as countries, industries and asset classes

ETFs are mostly passively managed, as they typically track a specific market index; they can be bought and sold like stocks, which is one of the biggest advantages of ETFs.

However, there are weaknesses that investors should not overlook.

Whenever investors buy or sell a stock, they need to pay a commission. This is also the case when it comes to buying and selling ETFs. Depending on how often you trade an ETF, trading fees can quickly add up and reduce your investment’s performance.

It is important to take note of the trading fees when investing in ETFs.

Investors also need to remember that actively trading ETFs, as with stocks, can severely reduce their investment performance as commissions pile up. As ETFs gain popularity, there has also been a rise in commission-free funds as well.

As such, investors are advised to adopt the lump sum approach when  trading an ETF. The rule here is to try to invest a lump sum at one time to cut down on brokerage fees.

According to a fund manager, another note for investors to be aware is the ETF’s expense ratio, which is a measure of what percentage of a fund’s total assets are required to cover various operating expenses each year. Essentially, the higher the expense ratio, the lower the total returns will be for investors.

Luckily, ETFs are known for having very low expense ratios relative to many other investment vehicles. For investors comparing multiple ETFs, this is definitely something to be aware of.

The fund manager says ETFs, like mutual funds, are often lauded for the diversification they offer investors. However, eventhugh an ETF contains more than one underlying position, it can be by volatility, which mainly depends on the scope of the fund.

An ETF that tracks a broad market index is likely to be less volatile than an ETF that tracks a specific industry or sector such as an oil services ETF.

As for international or global ETFs, the fundamentals and the creditworthiness of the currency of the country that the ETF is following are important. Economic and social instability will also play a huge role in determining the success of any ETF that invests in a particular country or region. Basically, investors need to know what the ETF is tracking and understand the underlying risks associated with it.

Many investors are against buying leveraged ETFs.These ETFs tend to experience value decay as time goes on and due to daily resets. This can happen even as an underlying index is thriving.

A financial advisor says lack of liquidity is one of the biggest concerns for investors looking at ETFs. If an ETF is thinly traded, investors would have difficulties getting out of the investment. The biggest sign of an illiquid investment is large spreads between the bid and ask. As such, make sure the ETF does not have large spreads between the bid and ask prices.

The price of an ETF can sometimes be different from that ETF’s underlying value. This can lead to situations in which an investor might actually pay a premium above and beyond the cost of the underlying stocks or commodities in an ETF portfolio just to buy that ETF. This is uncommon and is typically corrected over time, but it’s important to recognize as a risk one takes when buying or selling an ETF.

If investors want to avoid a particular company or industry due to moral conflict or whatever reasons, they should reconsider when looking at ETFs. This is because investors do not have a say in the individual stock in an ETF’s underlying index.

They cannot exclude stocks without eliminating his or her investment in the entire ETF.

Investors going into ETF investing should know what to expect from the performance. For instance, ETFs are most often linked to a benchmarking index, meaning that they are likely designed to not outperform that index.

Essentially, it is important to know all of the facts about a particular investment vehicle when making sound investment decisions and ETFs are no different. Knowing the disadvantages will help steer you away from potential pitfalls and lead to making tidy profits.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s