ETF’s have become very fashionable recently and their popularity has grown substantially in the last few years. ETF’s can make investing easy for the beginner as they take out the guess work in selecting stocks. They can also be a source of instant diversification for the investor who does not have the funds to buy a large portfolio of different shares. However, convenience always comes at a cost. For some investors who don’t need the convenience of an ETF, they may be better off not using them at all given some of the limitations of ETF investing. Some of the more common disadvantages of ETF investing include the following:

1. Management and Administration Fees

One major downside of investing in ETFs is they charge management and administrative fees which cover management of the investments, salaries, rent and other expenses and can add up to as much as 1%. This is included in the unit price but can erode the returns. Marketing costs that different ETFs providers incur as they compete for market share can add up. ETF’s with high expense ratios pose a higher risk of returns slippage than ETFs run with lower expenses.

2. Liquidity Issues

There can be a large bid/offer spread in the ETF and volumes can also be quite low. For an investor wishing to gain a decent exposure to the market or a theme, entry into and exit from an ETF holding can significantly impact returns if several layers of bid or offer are necessary to complete the transaction volume. This can lead to large gaps between your expected return and the outcome you ultimately achieve. Additionally, poor liquidity can also lead to the investor selling the ETF lower than the value of the underlying securities, destroying the investment case for entering the trade in the first place. ETF’s can involve market makers to provide liquidity, but the bid-offer spread here can also be a disadvantage.

3. Average Returns

ETF’s aim to track an index or an underlying security (wheat for example) as oppose to beating it. This product is suitable for an investor who is happy to invest in a “set and forget” strategy but generates average performance (less fees). If an investor is looking for higher returns, then investing in individual stocks would be a better strategy. There is a risk in picking stocks, but investors need to balance that risk if they are seeking a larger reward.

4. Tracking Error

Given points 1 and 2 above, many ETF’s don’t actually do a good job of tracking the underlying and you may have to select carefully depending upon which ETF tracks your target more closely. This additional effort to find the best vehicle to express your idea also comes at a time cost. Additionally, when an index rebalances (typically quarterly), the ETF tracking the index also must re-adjusted to maintain the desired tracking. This buying and selling of securities to rebalance incurs transaction costs, which will be paid by the fund which can cause further tracking difference and compress performance.

5. Overdiversification

Many ETF’s are passively managed and not actively managed. As these ETFs track an index, this can lead to ETF’s being over diversified with too many stocks. The investor may be better off buying individual stocks as they have more control in selecting the higher quality stocks over the lower quality stocks.

6. Tax implications

ETF’s are classified as a trust as opposed to company shares on a tax return. These ETF’s can create complex tax returns which can cause investors to pay more tax than is required. Some ETF’s also distribute capital gains to shareholders which then means the investor will be required to pay tax on that capital gain.

7. Currency Risk

The investor may be subjected to currency risk if the underlying holdings are different to the denominated currency. Many ETFs traded on the ASX are currency hedged back to Australian dollars. Where an ETF is currency adjusted in order to hedge such currency risks, there are hidden costs of FX transactions made in the process of hedging.

Lauren Hua is a private client adviser at Fairmont Equities.  

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