5 Common ETF Misconceptions

On 05/03/2013, in Exchange Traded Funds, by Jordan Wilson
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I like exchange traded funds (ETFs) versus open-ended mutual funds for most individuals.

ETFs provide many advantages for investors, especially those with limited capital.

But there are also aspects of ETFs that require attention. 

Investor use and demand for ETFs continues to grow. With more and more ETFs available, investors need to keep an eye on potential issues. My ETF writing usually mentions specific concerns when investing in ETFs. But Investopedia provides a nice summary in, “5 Common Misconceptions About ETFs”.

1. Leverage Is Always a Good Thing

Not sure this is a misconception about ETFs, rather a general investing statement.

Leverage amplifies impact on returns. If your investment is increasing in value, great. If falling, the loss is magnified.

ETFs tend to be relatively inexpensive investment vehicles, an advantage. But leverage employed within a fund increases both fund complexity and operating costs. Expect to see higher annual expense ratios in a leveraged fund versus a similar unleveraged fund.

2. There Are ETFs for Every Index

Probably not a real issue for investors. There exists a multitude of ETFs that encompass more than enough indices.

If you have advanced to the point where you are looking to invest in small-cap Egyptian common shares, you (hopefully) have the sophistication and capital to find investment options other than ETFs.

3. ETFs Only Track Indexes

A good thing for investors who wish to drill down into specific markets and sub-markets.

For smaller investors, stick to major indices and avoid components and market niches. As portfolio capital grows, then perhaps look at further diversification options. And, as investment expertise and experience strengthens, maybe consider sub-markets for tactical investment strategies. That said, I do not think most investors need to invest in sub-markets to ensure investment success.

Note that there are also a variety of other ETFs, including: Inverse ETFs; Life-Cycle ETFsAlternative Asset Class ETFs; ETF Wraps.

4. ETFs Always Have Lower Fees than Mutual Funds

Two points here.

One, most brokerage houses charge transaction fees when buying or selling ETFs. There are exceptions as certain brokers offer “no-transaction fee” ETFs on some of their offering.

If you are a small investor wanting to invest $100 each month, even a $10 commission hurts.

For very small investors, accumulate capital over time. Then when you reach a critical mass, invest. For example, save $100 each month and purchase a single fund every six months.

Or consider no-load, low-cost, open-ended index mutual funds. The annual expense ratio will probably be higher than with an ETF for the same index. But the no-load (i.e., no sales charge/commission on purchase or sale) component may more than offset the transaction fees on the ETF. Once a critical mass is reached (and you are safely outside any fund restrictions for short-term selling without a charge), you can redeem the fund and transfer the proceeds into the lower cost ETF.

Two, ceteris paribus, an ETF should have lower fees than an identical mutual fund.

But the same rule applies as with leverage. The more complex the ETF, the higher the annual expense ratio.

To the extent possible, focus on lower costs. That is a real key to investment success.

Plain-vanilla ETFs for major indices will have relatively low expense ratios. That said, costs do differ between ETF offerings, so compare before investing. As ETF complexity increases, expect costs to also increase. Do not blindly assume that ETF means inexpensive.

5. ETFs Are Always Passively Managed

As we saw above, there are ETFs covering all bases, including many actively managed ETFs. But at a higher cost than related passive funds.

For most small investors, low-cost passively managed ETFs should suffice. In fact, over time it is questionable whether actively managed funds consistently outperform passive.

Bottom Line

In general, I prefer ETFs to open-ended mutual funds. Usually, better liquidity, lower annual costs, less tracking error, etc.

If you are an extremely small investor, feel free to incur the higher operating costs by using no-load mutual funds to avoid transaction fees on the ETFs. Once capital grows, then switch to the cheaper ETF.

Remember that not all ETFs are the same. Costs, performance, and tracking error, vary between similar ETF brands. Do proper analysis and due diligence even with ETFs.

Always keep in mind that the greater the complexity of the fund or ETF, the greater the cost.

I suggest small investors keep it simple. 

Minimize costs, passively invest, and focus on your long-term investment objectives.

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