It’s no secret to investors of all kinds that exchange-traded funds (ETFs) have grown in popularity in recent years. ETFs are one of the most popular investment vehicles, mainly because they offer investors great returns with very low relative fees. Plus, they’re easy to buy and structured in a way that removes a lot of the detailed work of managing assets, so investors don’t need to worry about those things.
While it may not come as a surprise that ETFs are some of the most popular vehicles, the fact that ETFs should encourage caution among ardent investors. The pool of ETFs grows as everyday investor interest grows, and as the field becomes more crowded, some funds will naturally outperform others in popularity. Therefore, investors new to the field and overwhelmed by the size of the ETF space may be inclined to focus on the trendiest names. However, a recent report from Forbes suggests that this approach can be dangerous. (See also: A look at the growth of the ETF industry.)
Jump in without all the information
One of the risks of a fashion ETF is that it could attract newcomers to the ETF space. Because they are unfamiliar with ETFs, these investors may not recognize some of the inherent risks and other considerations necessary to make an informed investment in this space. ETFs track pre-existing indices and trade like stocks in order to provide investors with easy access to a basket of different names. They oppose more open mutual funds; ETFs are more likely to focus on investment themes or specific industries. For example, ETFs could be a good option for investors looking to broadly invest in the video game industry or legal marijuana.
However, what ETFs do not provide as a general rule is broad exposure. The ease with which investors can buy fashion ETFs can be deceptive, according to a Forbes report; more important is the liquidity of the underlying securities, according to Janelle Nelson, a former portfolio analyst at RBC. “Sometimes an underlying stock is 30% or 40% of the ETF. It might make more sense to buy the stock outright,” she explained. (For more information, see: The Rise of Social Responsibility ETFs.)
The dangers of gimmicks
The specialization and thematic structure of the ETF space has driven the creation of both legitimate and less legitimate funds. Following trends can prevent investors from taking the time to fully investigate their investments. Nielsen recommends only buying “quality ETFs with strong sponsors.” After all, ETFs that are easy to buy but hard to sell at a critical moment can have a big impact on investors. (See also: Top 3 ETFs to Invest in Water.)
The report recommends that when looking at small ETFs new to the industry, investors should look for funds with assets under management (AUM) of at least $50 million; smaller ETFs are more likely to fold unless backed by a major sponsor . This is not a temporary problem, as small ETFs are often closed due to insufficient asset levels to cover their costs.
In addition to general concerns about popular ETFs, Forbes issued a warning about timing. “If an ETF has been created, you’re usually not at the beginning of the curve,” Nielsen warns, adding, “you’re usually in the middle of the curve.” She went on to describe the relationship between sponsors and investors: “ETFs initiate One has to foresee enough needs, [attract] Investors and provide returns… If an ETF is built on a popular theme, that theme is usually already widely publicized. ”
In other words, investors flocking to a fashion ETF may have missed the best opportunity to capitalize on the ETF’s success. (For more reading, check out: Biggest ETF Risk.)