What are the disadvantages of investing in ETFs?
ETFs have many advantages, especially their simplicity and diversification, which make them interesting investment products for beginner investors. But what are the disadvantages of investing in ETFs?
Disadvantage 1: Trading Costs
ETFs are traded just like stocks, which means you can actively buy and sell ETFs during market hours. Many brokers charge fees for every transaction you make. Additionally, there is a difference between the buying and selling price of an ETF, which we call the spread. Make sure the difference between the buying and selling price doesn’t become too large, as this can quickly increase your costs.
When buying ETFs, it is important to choose a cost-effective broker. You can take a look at the best ETF brokers in the overview below:
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Disadvantage 2: Market Risk
Some investors incorrectly believe that there are no risks associated with ETFs. However, even when you invest in tens of different stocks with an ETF, you can still lose money. Sometimes something big happens that causes all markets to crash, such as the 2008 financial crisis or the beginning of the COVID-19 pandemic in 2020.
With an ETF, you also face market risk, which can result in a significant loss of money. You can somewhat protect yourself against market risk by investing gradually over time. For example, if you buy an ETF monthly and invest the same amount, you buy both at high and low prices.
Disadvantage 3: Lack of Liquidity
In some cases, it may be difficult to sell your ETF: in this case there is a lack of liquidity. When you invest in a small ETF, there may simply be a lack of buyers. You will then receive a worse price for your ETF, which results in a loss. Therefore, always research whether the fund you want to buy is sufficiently liquid.
Disadvantage 4: Dividend Leakage
Some funds pay out the dividend they receive to ETF holders. However, this can lead to dividend leakage. Different countries charge different tax rates on dividends, which can reduce your return on investment. You can read more about dividend leakage in this article.
Disadvantage 5: Limited Risk Diversification
A major advantage of ETFs is the high degree of risk diversification they provide. However, this diversification can sometimes be limited in practice. There are very specific ETFs that only invest in a certain sector. For example, if you invest in an ETF that only buys South Korean game companies, your diversification will be minimal.
But even with ETFs that focus on a broad market, you should carefully investigate whether there is really a high degree of diversification. For example, within some indexes, you may see that a handful of companies have a very large weight compared to other companies. An investment in a Nasdaq ETF, mainly consists of Apple, Microsoft, Amazon, Alphabet, and to a much lesser extent, a series of other companies.
Therefore, always study how the ETF is constructed in detail to avoid unpleasant surprises. I personally use Morningstar to obtain information about various funds.
Disadvantage 6: be careful with leverage
Leveraged ETFs are risky and have a much higher degree of volatility. In addition, using leverage costs money, which means that these types of ETFs can perform poorly even during good economic times.
Disadvantage 7: no control
Another disadvantage of investing in ETFs is that you have no control. When you buy individual shares, you can make decisions about which companies to invest in completely on your own. For example, if you do not want to invest in environmentally polluting companies due to personal conviction, you can avoid doing so. However, with an ETF, you have no say in what happens to your money.
If you prefer to buy individual stocks, you can learn how to do this in in our manual:
Disadvantage 8: no high returns
ETFs are designed to track an index, not to beat it. Therefore, you will not achieve astronomical returns with an ETF. In a time when cryptocurrencies sometimes achieve thousands of percent returns in a short time, this can be painful. However, do not forget that most people achieve worse results by actively trading the markets.
If you are interested in how to achieve higher returns, our article on achieving a high return can be interesting:
Disadvantage 9: tracking error
Although the basic principle is simple, it is often difficult in practice to follow an index accurately. Indexes always charge some money to cover the management costs. Besides this, timing the distribition of dividends and rebalancing the ETF can be challenging.
As a result, the price of an ETF may deviate from that of the underlying index. When this deviation becomes significant, investors can lose a considerable amount of money.
Disadvantage 10: adjustments to the underlying index
When investing in ETFs, it is essential to consider the hidden costs of the underlying index. Research shows, for example, that a fund often incurs losses when it has to make adjustments. An ETF that tracks the NYSE, will have to buy and sell shares regularly to continue tracking the index. Other market players are aware of this and can use this fact to their advantage.
They then sell the shares that the fund will have to sell later and buy the shares that the fund has to buy. As a result, the fund receives less money for the shares it needs to sell and pays more for the shares it needs to buy. These hidden costs can significantly reduce the return of an ETF that tracks an index.
When a fund delays making these adjustments, you often see that this has a favorable effect on returns.
Disadvantage 11: closure risk
If an ETF fails to attract enough customers, it may be closed. The ETF is then liquidated, and as an investor, you receive the value at that time. However, if the ETF has lost value in the meantime, you may incur a significant loss.
Disadvantage 12: rising costs
The average annual management fee for an ETF is about 0.4%. However, you will see that new funds are often offered at much higher prices. An ETF for which you pay 1% is less rare than you might think. Therefore, it is highly recommended to thoroughly research the ETF in which you want to invest. An ETF should never charge a very high cost percentage, as it is a completely passive investment.
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