Financial Planning Blog

In Part 2 we looked at some of the advantages of ETFs, and how they might be useful in creating a diversified, low cost portfolio. However, not everyone is keen on ETFs for the individual investor. John Bogle, who I highly respect, is one of the primary critics of ETFs. Although, as this interview by Morningstar points out, he is not opposed to utilizing ETFs for long-term, index fund investing--just as you would use index mutual funds. So, what are the problems with ETF's, and what should you look out for?

The dark side of ETFs 

The double edged sword of ETFs is that they are easy to trade. Most of the trading volume of ETFs is from active traders and institutions. While this keeps the market efficient and insures that the most popular ETFs are trading very close to their NAV, active trading of ETFs (or stocks or mutual funds) is a recipe for high costs and lower returns for most individual investors. For those of us who generally buy, hold and trade only to occasionally rebalance our portfolio, ETFs are a good product. Just because you can trade them all day long, doesn't mean you should! 

Another problem with ETFs is the extreme number of different indexes and market sectors that you can invest in. It is a ripe playground for market-timers and active investors to jump in and out of hot sectors on every whim. Just because you can invest in a small cap Brazil index, or the biotech sector, doesn't mean it's a good idea. Remember, you should have these sectors covered with broader US and international index funds. Don't kid yourself about your ability to identify the hot sector in time to profit from it. And, not only is utilizing too many sector and country indexes a complicated and doubtful strategy, but these funds are often more thinly traded. This exposes you to higher transaction costs from larger bid/ask spreads and potential discounts and premiums relative to the NAV of the fund.

Finally, there are many dangerous ETFs to be avoided. These include leveraged, inverse, and leveraged inverse ETFs. With leveraged ETFs, your gains and losses are multiplied by leverage within the fund. With inverse ETFs, you gain when the index goes down, and vice versa. If this sounds complicated and risky, it's because it is. We mere mortals should stay far away.

In conclusion, ETFs are useful for the disciplined individual investor who wants to follow a low cost, passive investing strategy. If you want to learn more about to build a diversified portfolio to help you reach your goals, contact Table Rock Financial Planning today.