Common misconceptions about ETFs

For decades, mutual funds have provided professional portfolio management, diversification and convenience for investors who lack the time or means to trade their portfolios in a profitable manner. In recent years, a new type of mutual fund has emerged, with many of the same advantages as traditional open-end funds, but with much greater liquidity. These funds, called exchange-traded funds (ETFs), are traded on public exchanges and can be bought and sold during market hours like stocks.

However, the increasing popularity of these funds has also caused a lot of misinformation about ETFs. This article explores some common misconceptions surrounding ETFs and how they operate.

Key points

  • Exchange-traded funds are usually named after their acronym ETF, and they have become an increasingly popular investment tool for individuals and institutions.
  • Although ETFs are often touted as a low-cost way to gain passive index investment exposure, not all ETFs have low management fees, and not all ETFs are passively managed.
  • Other misconceptions include the breadth of ETF products, the use of leverage to increase ETF returns, and that they are always preferable to comparable mutual funds.

Leverage is always a good thing

Variants of ETFs can use different degrees of leverage to achieve returns that are directly or inversely higher than the underlying index, industry or security group on which they are based. The leverage ratio of most of these funds is usually as high as 3 times, which can magnify the gains from the underlying tools and provide investors with huge, fast profits. Of course, leverage works in both directions, and people who make the wrong bet may suffer huge losses in a hurry.

In some cases, the cost of maintaining leveraged positions in these funds is also considerable. Portfolio managers need to buy positions when prices are high and sell when prices are low to rebalance their holdings, which may significantly erode the return of the fund in a relatively short period of time. However, perhaps most importantly, because the effect of compound interest mathematically undermines the fund’s ability to track its index, many leveraged funds will never publish returns or other benchmarks consistent with their leverage ratio for more than a day.

ETF for every index

Many investors believe that every existing index or industry has an ETF available, but this is not the case. There are many securities or economic sector indexes in underdeveloped countries and regions, and no sector funds are based on them (such as India’s CNX service sector or mid-cap index). In addition, an ETF does not always buy all the securities that make up an index or industry, especially when it consists of thousands of securities, such as the Wilshire 5000 index. Funds that follow this type of index usually only buy a sample of all securities in the industry or index, and use derivatives that can increase the fund’s return. In this way, the fund can closely track the returns of the index or benchmark in an economic way.

ETF only tracks the index

Another common misconception about ETFs is that they only track indexes. ETFs can track industries such as technology and healthcare, commodities such as real estate and precious metals, and currencies. Today, there are very few types of assets or industries that do not have ETFs covering them in some form.

ETF fees are always lower than mutual funds

ETFs can usually be bought and sold at the same commissions charged for trading stocks or other securities. For this reason, as long as the transaction volume is large, their purchase costs will be much cheaper than open-end mutual funds. For example, an investment of US$100,000 may be invested in an ETF with an online commission of US$10, while the load fund will charge 1% to 6% of assets. However, for small regular investments, such as a USD 100 per month cost averaging plan, ETFs are not a good choice, and the same commission must be paid for each purchase. ETFs do not provide breakpoint sales like traditional load funds.

ETF is always passively managed

Although many ETFs are still similar to UITs because they consist of a portfolio of securities that reset regularly, the world of ETFs is more than just SPDRS, diamonds, and QQQ (“cubes”). In recent years, actively managed ETFs have emerged and are likely to continue to receive attention in the future.

Other misunderstandings and restrictions

Despite the attractive liquidity and efficiency of ETFs, critics insist that they allow investors to trade in the same day as any other publicly traded securities, thereby undermining the traditional purpose of mutual funds as long-term investments. Compared to paying only $10 or $20 in commissions to online brokers, investors who have to pay 4% to 5% of sales fees are much less likely to liquidate their positions when stock prices fall two weeks after purchase. Short-term transactions also negate tax liquidity in these instruments.

In addition, sometimes due to the inefficiency of the investment portfolio, the net asset value of the ETF may differ from its actual closing price by several percentage points. There is also speculation that ETFs are used to manipulate the market, which may have caused the market crash in 2008. Finally, some analysts believe that many ETFs do not provide sufficient diversification on a per-fund basis. Some funds tend to focus on a few stocks, or invest in fairly narrow securities areas, such as biotech stocks. Although these funds are useful in certain situations, investors seeking broad market access should not use them.

Bottom line

ETFs have many advantages over traditional open-end mutual funds in many aspects, such as liquidity, tax efficiency, and low fees and commissions. However, there is a lot of misinformation about these funds. They do not cover all indexes and industries, and their efficiency and diversification also have certain limitations. Their liquidity can also encourage short-term transactions that may not be suitable for some investors.

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