The Problem with ETFs

ETF

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.

26 thoughts on “The Problem with ETFs

  1. R2R,

    The 10% of my portfolio that I have invested in stocks is in my Roth 401K and my wife’s Roth 401K. Since these are both within company plans, I am limited to what funds are available to invest in. My investments are split between a S&P 500 index fund, a Targeted Retirement fund (stocks and bonds), and a stable value fund. I chose these three to provide decent upside return while limiting the downward drops and at the same time minimizing the management expense fees.

    I used to be a stock picker and had my share of spectacular returns and ugly losses. I now focus my efforts on identifying alternative income producing investments as opposed to finding the next hot stock roller coaster to ride. I find the balanced approach that I have chosen with ETF’s and managed funds provide market participation with low expenses and low volatility.

    Regards,

    Deets

    • Deets,
      Thanks for sharing. Those are good funds to choose, esp when you have a limited option for picking your investment. I think the combination is a great one considering your retirement requirements.
      Good to hear that you had your years of stock picking ups and downs. I am very impressed with your approach to alternative investments. Its a great way of generating spectacular returns.

      Best wishes
      R2R

  2. Hey R2R. Thank you for the post. I agree with your points. I’d also like to add that in investing, why can’t we do both? That’s what I’ve been leaning towards. Individual stocks AND.. ETF investing. I’d personally like to follow the Canadian Couch Potato model portfolio. 25% Canadian / 25 % US / 25 % Emerging & EAFE / 25 % bonds. Just 4 or 5 more purchases on top of our individual stocks. To each their own and everyone should know their wants and needs. Thank you for time bud.

    • Exactly my viewpoint, DH 🙂
      I use a combination of stocks and ETFs. Like I mentioned in the article, Ive used ETFs in the past in my own portfolio and now down to just a couple and use ETFs exclusively in my wife’s portfolio. ETFs provide access to some companies that I wouldnt find comfortable investing directly in. But the diluted effect works for me, which I think is true for most investors choosing a small cap index fund, for example.

      cheers
      R2R

  3. JC says:

    I don’t have any ETFs in my portfolio but I do own MFs in a rollover IRA, Roth IRA, and my 401k. They have a place in most portfolios and it really depends on what your objectives are and how active you want to be with your investing. You can be much more selective with your investment criteria by investing on your own but you give up the instant broad diversification of MF/ETFs.

    • Agreed, JC.
      Theres probably a place for funds even for DGIs like us. Most importantly, but not limited to – for bond/fixed income exposure. We cant buy bonds directly (well, technically we can – but its not worth the increased risk), so ETFs are teh way to go. Same goes for investing in some equities. It creates a unique opportunity, but I wanted to highlight what the disadvantages are of simply following an approach blindly.

      Thanks for stopping by and sharing.
      R2R

  4. I agree with you – there is always an index that is doing better than you. Plus, there are so many indexes that actually constructing an index portfolio is similar to picking stocks. You need US large, small, mid cap, value, growth, then international large, small, midcap, -value and growth, then emerging, frontier, then different types of bonds etc,. The end result is a hodge podge of funds and investments. Plus, no 2 index fund investors are the same – some hold only US stocks, others hold US stocks and bonds, while another might own US, International Stocks and some bonds. So you can see indexing is not a foolproof method as it is thought out to be.
    The thing of course is that different investors have different goals and objectives. For many, those who are busy with work and life and have no desire to spend time on investments, an index fund portfolio could be best. For those like me, who have specific goals and objectives, dividend stocks are the best way to achieve my goals.
    And to be honest, I believe over the next 30 years, a portfolio of a dividend growth investor of today will likely do much better than the portfolio of the typical index investor who has a 33 – 50% allocation to bonds.

    • Thanks for sharing your thoughts, DGI. Thats right – with so many different options available, which index does one pick. I still dont shy away completely from using them though, even though its really tough to pick one. But once picked, I think like stocks, you should stick to it and not try to jump from one to the other every year.
      Good point on the fact that no two index fund investors are alike – what works for one doesnt work for the other and each unique combination can result in a different overall return number. This is what attracted me to DGI in the first place – that over the long term, the income keeps growing from the investments and also a great way to build the underlying capital.

      Cheers
      R2R

  5. I personally use a mix of ETF’s and direct holdings. For a very specific type of person it’s a great idea to occasionally make long-term buy and hold purchases or even the occasional speculative trade. Having said that:

    The single most important point is that 99% of people have neither the time, inclination, skill set or correct emotional makeup to pick stocks, which is why most investors don’t manage to make anywhere close to the benchmarks. They buy what’s hot, sell at bottoms, and buy at tops. If you could convince the masses to just pick a basic asset allocation, invest the same amount every month, and pretend it doesn’t exist, it would be a pretty great boon to most all average people.

    I also think it’s pretty easy to build that asset allocation if you genuinely want to be passive. It can be as simple as 2 Vanguard funds (VTI, VXUS) and you’ve covered virtually the entire world. That’s what I recommend to all my friends and family.

    • Thats the key point, Adam. If we all could take out emotion and personal behaviors out of investing, we would all do so much better. Unfortunately, its human nature to do so. Even the technical trading is a dubious method. We humans are wired to look for patterns even when they dont exist and try to make sense of things that have no correlation.
      Passive investing is a great way to build your nest egg if one doesnt have the time, inclination or skillset to pick and invest in stocks. Good recommendations going out there 🙂

      Thanks for stopping by
      R2R

  6. Agree. I primarily invest in broad index ETFs in my portfolio, but this is more a matter of capital preservation, simplicity, and risk management. I was greedier for juicy dividends and big capital gains when I had a small amount of money, but I’ve found as my nest-egg has grown I just want it to stay relatively safe and not take too much management.

    I still like to buy individual stocks for various purposes: high dividend payouts, speculation, diversification, but for the most part ETFs handle the bulk of my wealth!

    • Bridget,
      Welcome to my blog and thanks for sharing your thoughts.
      Index ETFs can be a good tool for diversification, but it is important to watch and understand the underlying holdings closely. Like I mentioned in the article, buying a ZCN.TO may give the impression that one is well diversified and has exposure to the whole Canadian market, but over a third of the holdings are in the financial sector. I dont have people following one investing strategy against another – as long they understand what they are doing. I gather that you have done the work and have proper diversification to protect your assets. Good to hear that you still dabble in div stocks 🙂

      Best wishes
      R2R

  7. Great topic R2R, I personally like individual stocks but my 401K have mutual funds and bonds. As for my wife, I see Vanguard mutual fund fit for her, she can keep on contributing to it and forget about it (with minimal management) and like you mentioned it has low cost. She is not much of an investor but I push her to invest and I have to encourage her to invest regularly on a monthly basis.

    The good thing about investing is there is so many options that can fit everybody’s needs and style of investing. We just have to figure out what fits our lifestyle and stick with it.

    Take care!

    • Exactly, FFF. There are so many different options and theres something for everyone.
      Your wife sounds a bit like my wife, although I dont have to push her or convince her to keep investing. She just puts the money away into investments accounts and forgets about it. Thats why I went with ETFs for her portfolio, although she still holds one mutual fund in another account.

      cheers
      R2R

  8. You have good points here… I’m primarily dividend focused but have been slowly adding some index ETF’s to our portfolio to further diversify internationally. It’s simply not possible to own some of these international stocks via ADR’s.

    • Thats definitely one reason to own ETFs…if international stocks are to be invested in, direct stock investment is probably not possible in most cases. A great way to track international equity markets for sure, with the ETFs.

      Thanks for sharing
      R2R

  9. Sam the Man says:

    I’m currently overweight in the U.S market and the exchange rate is not helping, so I decided to invest in the Canadian TSX.

    I would like to stick with individual stocks but I don’t find many compelling dividend growth stocks to choose from. So that’s why I decided to invest in couple of Canadian ETF’s.

    • Sam,
      Thanks for stopping by and sharing your thoughts. The exchange rate definitely is working against us in Canada, but its good news for the manufacturers and especially for companies which derive their revenues overseas, esp the US. Have a look at companies Magna, Agrium, Canadian National etc. MG is trading at quite a discount and offer good global diversification – although its concentrated on the auto sector. If you are looking for broad exposure, ETFs are probably the way to go.

      cheers
      R2R

      • Sam the Man says:

        Thanks for reply and recommendations. Currently, I owe the “big 5” Canadian financial banks. Not looking to add more oil stocks to my portfolio.

        This is what I’m planning to buy next month:

        Canadian Utilities Limited (CU)
        SNC-Lavalin Group Inc (SNC)
        Magna International Inc. (MG)

        • Sam,
          Thanks for sharing. Those are some really good companies. I dont closely follow CU and SNC….but I heard about the bribery allegations on SNC – saw some ppl commenting that it could badly damage the company’s reputation and a hefty fine. Hopefully you’ve evaluated all that.
          Cant go wrong with Magna, esp at these prices.

          Happy investing
          R2R

  10. Nice post R2R. I hold a few ETFs myself in various sectors and one of the main reasons I got those was to get exposure to multiple stocks quickly and easily. But expense ratio and the holdings within the ETF are couple of items that I look for in an ETF before getting it. I hold couple of Vanguard ones (VWO and VPU) and couple more (SCHD and XLK) and all have very low expenses.

    • DGJ,
      Same here…I look for those things in my ETFs as well. I like those Vanguars ETFs and have considered it in the past.

      Thanks for stopping by and sharing your thoughts
      R2R

  11. I think ETFs are good if you are someone who wants to invest but don’t have the interest or knowledge to analyze individual companies. Some people want to just put their money in and get their returns. I actually tried to help a friend of mine pick a couple of index funds since I knew he would never have the patience to analyze a business.

    To sort of build on your first point, R2R, since anyone can make that argument against any sort of investment, how does one even value and analyze a fund? I can analyze a business independent of market and macroeconomic factors (such as analyzing Exxon Mobil independent of the current low oil prices). How can one do the same for a fund (if you have an oil ETF, it is based entirely on the current oil prices and state of the sector)? The only way to do that would be to analyze the individual companies, at which point you might as well buy them on their own. If a fund is a collection of individual stocks, how does one analyze the fund on its own without focusing on the macroeconomic factors, a very bad practice in stock analysis.

    Also, I don’t think the per transaction costs are an issue (the same as individual stocks) as much as the annual fees. Why would anyone want the fund manageres taking a half a percent or whatever from your total holdings?

    I honestly think that if you have the interest and know-how to analyze individual businesses, then you should not even bother with ETFs and just buy stocks.

    Sincerely,
    ARB–Angry Retail Banker

    • I agree, ARB. Most ppl out there do not have the time or inclination for investing directly in stocks. ETFs make perfect sense for them.

      Your building on the argument is very interesting…and I agree that once you make the jump from investing in a business to a sector or something based o macro factors, its a whole different ballgame. The metrics change, the players change and things have to be approach from a different viewpoint. Thanks for sharing the insight.

      R2R

  12. Hey R2R,

    Let me counter-counter-argument some of your counter-arguments!

    • The biggest problem with index investing and ETFs, I think, is – Which index do you pick?!

    Yeah, ETF’s have gotten very popular. Hence the amazing variety. But that’s a nice problem, no ? I’d rather have many flavour of ice creams than only two or three. Isn’t it the case too with good dividend paying stocks too ? Which one to pick ? Tough call.

    • You get the good with the bad.

    Again, it’s the same with a portfolio of 40-50 stocks (sometimes more !). The more stocks you hold, the better chances you have of hitting a bad apple. So it’s not very different than ETF’s in the regard.

    • Dividend raises are subdued.

    Not sure this argument is entirely true. But since I’m not an ETF’s expert I will let someone else answer it. As far as I know, you can get the reap of dividends through ETS’s. Some of those actualy are called Dividends ETFs…

    • There are some other issues too – such as transaction costs.

    Again, same with stock picking. If you buy small amount of shares regularly you will also end up paying a lot of commissions.

    I think it all comes down to : how many stocks is needed to be diviersfied for a stock picker ? And to what number you might as well be investing in ETF’s ?

    My guess is, passed 20 to 25 stocks, you might as well buy 2-3 ETF’s (35%US, 35%CAN and 30%Bonds) and let it roll for the next 30 years.

    Thanks for the post R2R. It raises a lot of good questions !

    • MD,
      Thank for stopping by and countering the counter-arguments 🙂 Im sure we can keep going back and forth on these points.

      > Yeah, ETF’s have gotten very popular. Hence the amazing variety. But that’s a nice problem, no ? I’d rather have many flavour of ice creams than only two or three. Isn’t it the case too with good dividend paying stocks too ? Which one to pick ? Tough call.
      Its a good problem to have for people who are interested in investing and dont mind it. I know a lot of folks (including my wife) who just want one investment to pick and let it be passive over the long run. Its a classic case of too many options end up confusing you more than having just one or two.

      > Again, it’s the same with a portfolio of 40-50 stocks (sometimes more !). The more stocks you hold, the better chances you have of hitting a bad apple. So it’s not very different than ETF’s in the regard.
      True. I just wanted to point out that when you buy your ETF, you have to live with the consequences that a company belongs to an index and swallow it. If I own stocks, I can get rid of the bad apples.

      > Not sure this argument is entirely true. But since I’m not an ETF’s expert I will let someone else answer it. As far as I know, you can get the reap of dividends through ETS’s. Some of those actualy are called Dividends ETFs…
      I think ETFs specializing in this space havent been around long enough to prove one way or another. That is why I was careful to say that the results are subdued compared to direct increases passed on shareholders when you buy the stock.

      > Again, same with stock picking. If you buy small amount of shares regularly you will also end up paying a lot of commissions.
      No arguments there 🙂

      You are right about the diversification. Studies have shown that as little as 12 stocks can reduce your risk by a large amount. So, the diversification by simply buying an ETF is almost instantly achievable (provided its not an ETF focused on one area).

      Thanks for the feedback, MD. Definitely some good points raised and food for thought.
      R2R

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