For decades, mutual funds have provided professional portfolio management, diversification and convenience to investors who lack the time or means to trade their portfolios profitably. In the 1990s, a new generation of mutual funds emerged, offering many of the same benefits as traditional open-end funds, with 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 generated a lot of misinformation about ETFs. This article examines some of the common misconceptions about ETFs and how they work.
- Exchange-traded funds, or 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 that they are always preferable to a comparable mutual fund.
Leverage is always a good thing
Some ETFs use leverage to achieve returns that, directly or inversely, amplify movements in the underlying index, sector or group of securities on which the fund is based. Most of these funds typically have leverage of up to three, which can magnify the gains made by the underlying vehicles and generate huge, quick profits for investors. Of course, leverage works both ways, and those who bet poorly can suffer big losses in a hurry.
The costs of maintaining leveraged positions in these funds are also quite high in some cases. Portfolio managers are required to buy positions when prices are high and sell when they are low, in order to rebalance their holdings, which can significantly erode the returns posted by the fund over a relatively short period of time. However, perhaps most importantly, many leveraged funds simply do not show returns in line with their leverage ratio over periods longer than one day, due to the he effect of compound returns which mathematically disrupts the fund's ability to track its index. or another reference.
There are ETFs for each index
Many investors think that there is an ETF available for every index or sector in existence, but this is not the case. There are many stock or economic sector indices in emerging markets and regions that do not have any sector funds available to U.S. investors, such as the MSCI Indonesia SMID Cap Index or the Indian Healthcare Sector.
Additionally, ETFs don't always buy all of the securities that make up an index or sector, especially if it is made up of several thousand securities, like the Wilshire 5000 Index. Funds that track indexes like this often buy only a sample of all securities in the sector or index and use derivatives that can increase the returns posted by the fund. In this way, the fund can closely track the performance of the index or benchmark in a cost-effective manner.
Total assets of all ETFs worldwide, as of Q3 2023.
ETFs only track indices
Another common misconception about ETFs is that they only track indexes. ETFs can track sectors such as technology and healthcare, commodities such as real estate and precious metals, and currencies. Today, there are few types of assets or sectors that are not covered by an ETF in some form.
ETFs still have lower fees than mutual funds
ETFs can generally be bought and sold for the same type of commission charged for trading stocks or other securities. For this reason, they can be much cheaper to purchase than open-end mutual funds, provided a significant amount is traded. For example, a $100,000 investment can be made in an ETF for a $10 online fee, whereas a fee-based fund would charge between 1 and 6 percent of assets. However, ETFs are not a good choice for small, periodic investments, such as a $100 per month periodic investment plan, where the same commission would have to be paid for each purchase. ETFs do not offer breakpoint sales like traditional loading funds.
ETFs are still passively managed
Although many ETFs still resemble UITs, in that they are comprised of a defined portfolio of securities that are periodically reset, the world of ETFs is not limited to SPDRS, Diamonds, and 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 long-term investments by allowing investors to trade them intraday like any other. what other stock listed on the stock exchange. Investors who have to pay a 4-5% sales charge will be much less likely to liquidate their positions when the stock price falls two weeks after purchase than they would if they only had to pay a commission of $10 or $20 to their online broker. Short-term trading also negates the fiscal liquidity found in these vehicles.
Additionally, there are times when an ETF's net asset value can vary by a few percentage points from its actual closing price due to portfolio inefficiencies. Finally, some analysts believe that smaller 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 stocks. Although these funds are useful in some cases, they should not be used by investors seeking broad exposure to the markets.
Is an ETF the same as an index fund?
Many exchange-traded funds are also index funds, meaning they are structured to track the assets and returns of a stock index. However, not all ETFs are index funds, and not all index funds are ETFs. As with any other security, it is important to research a fund's prospectus carefully before making an investment.
What is the biggest risk in ETFs?
The biggest risk for ETFs is market risk, which is the risk that the underlying index or sector faces an economic downturn. Although ETFs are more diversified than individual stocks, they remain vulnerable to market-wide movements.
Are ETFs cheaper than mutual funds?
Historically, ETFs have lower expenses than mutual funds due to active management costs. However, some ETFs have relatively high expenses, particularly those dealing with high leverage or specialized assets such as cryptocurrencies. As with any other investment, it is important to research an asset thoroughly before making an investment decision.
ETFs offer a number of advantages over traditional open-end mutual funds in many respects, such as liquidity, tax efficiency and low fees and commissions. However, there is a lot of misinformation circulating about these funds. They do not cover all indices and sectors, and their effectiveness and diversification have certain limits. Their liquidity may also encourage short-term trading which may not be suitable for some investors.