We read everyday on the media sites and blogs across the web that Exchange Traded Funds (ETFs) are the best options for investors as they are a cheaper alternative to mutual funds and are a great way to invest. While I agree with that viewpoint, I think it is important to also consider the problem with ETFs.
This post is inspired by a comment from Monsieur Dividende on my post on The Importance of Diversification. In that article, I discussed why it is important to diversify and how studies have shown that unique risk decreases significantly even with as little as 12 stocks in a portfolio. MD made a point that once you get to a high number of holdings, say 40-50 stocks, you are better off simply owning an ETF. While I agree that most investors are better off investing using ETFs, I have a couple of counter arguments to that point.
The Problem with ETFs
- The biggest problem with index investing and ETFs, I think, is – Which index do you pick?! NoMoreWaffles had a good post about this a few days ago. People always like to compare market performance – but which market would/should you pick? There are hundreds, if not thousands, of indexes across the world. You might say, pick S&P 500 – that the most important and popular one. I bet the media will come out with rankings at the end of the year saying that some emerging market did better than the US market (or the small caps did better than large caps), so you should have picked that other one instead! We all know that the human nature of trying to jump from one ship to the another constantly is what causes a drag on overall returns. My take on this is that it is a fool’s errand to try and beat the market and more importantly even picking the market is a complicated process. My philosophy has always been to not focus on the annual ups and downs (let alone the quarterly or monthly ups and downs) but rather simply focus on growing my income stream by investing in dividend growing companies and supplement that with other sources such as bonds, commodities and other sources.
- You get the good with the bad. Even with a broad index, there might be a high weight dedicated to one sector of the economy. For e.g., if you buy an index to track the Canadian equities market such as the BMO S&P/TSX Capped Composite Index ETF (ZCN.TO), nearly 35% of the index is invested in the Financials sector. The top 10 holdings comprise nearly 36% of the portfolio. If you happened to choose just this one index thinking that you are invested in a broad index that tracks the whole Canadian economy, you might end up in hot water if the Canadian financial sector takes a dive. Again, I am not suggesting that its a bad idea to use these ETFs (case in point, we actually use the aforementioned ETF in my wife’s portfolio for Canadian market exposure).
- Dividend raises are subdued. This is more related to income-focused investors who either depend on dividends for living and paying bills or to grow their income stream over the years. ETFs havent been around that long and do not have the track record of passing on the dividend raises – the raises from each company are subdued and diluted due to the rest of the ETF holdings. The kind of dividend growth achievable by investing in individual companies is not matched by investing in ETFs.
- There are some other issues too – such as transaction costs. The MER cost of the ETF might be low, but if your broker charges you for each transaction and you decide to trade in and out of ETFs, you may end up with higher fees than the high mutual fund fees you first wanted to avoid.
So, am I saying that you need to sell your ETFs and go buy individual stocks? No. Not at all. I still think that for most people investing via low-cost ETFs is the way to go. I own ETFs myself – both as part of my own investment portfolio and my wife’s portfolio. But it is important to know where the gaps are and what the limitations of investing via ETFs are.
What are your thoughts on the problems discussed here? Do you agree? Do you have any other issues that you consider worth mentioning? Share your thoughts below.
Full Disclosure: Long ZCN.TO. My full list of holdings is available here.