ETFs are cheap, diverse, and simple to trade, but they also have hidden risks like trading costs, market risk, liquidity risk, and sector concentration. Pick your ETFs carefully to avoid these.
Are ETFs really the perfect investment?
You may think that exchange-traded funds (ETFs) are the best thing that has ever happened to your portfolio because they are cheap, diverse, and easy to trade. But here’s the catch: like any other financial tool, ETFs have hidden problems that could slowly eat away at your profits. Before you dive in, let’s talk about the bad things about ETFs.
Disadvantages of Investing in Exchange-traded Funds
1. Trading Costs That Sneak Up on You
ETFs are known for having low annual fees, but you still have to pay a commission every time you buy or sell. These small transaction fees can add up quickly if you’re using a dollar-cost averaging strategy and putting ₹5,000 into the market every month. If you pay ₹20 to ₹50 for each trade, that’s ₹240 to ₹600 in brokerage fees over 12 months, which can lower your total returns without you even knowing it.
Furthermore, niche ETFs usually have bigger bid-ask spreads, which means you might pay more than you should or sell for less, especially in fast-moving markets or for ETFs that don’t trade frequently.
2. Less Diversification Than You Think
Not all ETFs are the same. Many country- or sector-specific ETFs only give you a small part of the market. If you invest in a technology ETF, for instance, you might not realize that a lot of your money is going into just five or six big tech companies, missing out on chances to invest in smaller and mid-sized companies that are growing.
This limited exposure goes against the whole point of diversification, which is one of the main benefits of ETFs.
3. Intraday Trading Temptation
ETFs can be traded all day, which may seem like a good thing, but it’s a double-edged sword. Intraday pricing can make you trade when you don’t need to because prices are moving quickly. Short-term noise can distract long-term investors and make them make emotional decisions that get in the way of their investment goals.
For example, if the ETF price drops 3% in the middle of the day, an investor might panic and sell, only to see the market bounce back by the end of the day. A mutual fund, which only costs you once a day, protects you from this mental trap.
4. A higher cost than buying individual stocks
Let’s say you want to compare buying an ETF that tracks a group of stocks to buying one of them directly. The ETF does give you diversification, but it also has management fees, even if they are small, and there is a chance of tracking errors. Stocks, on the other hand, don’t have any ongoing management costs.
Furthermore, if you want high-dividend returns, some dividend-paying stocks pay 6–7%, but comparable dividend ETFs might only pay 3–4% because they invest in a wide range of companies.
5. Lower Dividend Yields
Many people think that ETFs pay out big dividends, which is not true. In reality, dividend ETFs usually average out the yield, so you don’t get to choose high-paying stocks.
If Stock A pays a 9% dividend and Stock B pays a 2% dividend, an ETF that holds both stocks might give you an average yield of 5–6%. If you want steady, high passive income, that’s not as exciting.
6. Leveraged ETFs: Risky and Complex
While leveraged ETFs aim to increase gains, they also increase losses. A 2x leveraged ETF could lose 2% or more if the underlying index drops by 1%. Because of daily compounding, these leveraged ETFs can perform very differently from the index over longer holding periods.
Let’s say you put ₹10,000 into an energy ETF with 2x leverage. If the energy index declined by 5%, you could lose ₹1,000 right away. You should only use these ETFs for short-term trades, not long-term investments.
What Are the Risks of Investing in ETFs?
1. Market Risk
ETFs don’t protect you from the fact that the stock, bond, or commodity markets are constantly changing. Your ETF will go down if the whole market goes down. For example, an ETF that follows Indian mid-cap stocks could lose 20% in a bear market, just like the broader index.
2. Tracking Error
This scenario happens when an ETF doesn’t follow its target index correctly. It could be because the fund is poorly managed, there are tax consequences, or the index isn’t fully replicated. If you make a small mistake of 1–2% every year, it can add up over time and hurt your returns a lot.
3. Liquidity Risk
Some ETFs are difficult to trade. If your ETF has illiquid assets, like foreign bonds or niche commodities, it might be difficult to sell them quickly in a crisis. Low trading volume also means that the bid/ask spreads are wider, which makes it pricier for you to get out.
4. Sector Concentration
Many ETFs are very focused on a small number of sectors or stocks. For example, a ‘dividend ETF’ might have too much money in utilities and finances. Your ETF will lose a lot of money if those sectors perform poorly, even if the rest of the market does well.
5. Single-Stock Concentration
Despite their ‘diversified’ labels, many ETFs contain a few large holdings. For example, tech ETFs often have 25–40% of their money in only three or four companies, such as Apple, Microsoft, and Google. If one of these stocks drops considerably, it could have a big effect on how well your ETF does.
Why ETFs Are Bad for the Long Term
- Overtrading Temptation: The ability to trade ETFs quickly during the day may tempt long-term investors to make short-term decisions.
- Diluted Returns: Sometimes having a wider range of investments means getting average returns. You might miss out on chances to beat the market that are only available in certain stocks.
- Cost Creep Over Time: ETF fees are low, but they add up over time. A ₹5 lakh portfolio with a 0.5% expense ratio each year will grow to ₹25,000 in 10 years.
- Changing Fund Strategies: Some ETFs change their strategies or indices without warning, which can surprise investors. A large-cap ETF might slowly add mid-caps, which would change the risk profile.
Final Thoughts
Exchange-traded funds are easy to use, clear, and cheap, but they do have some problems. ETFs have some problems, like hidden trading costs, sector concentration, and tracking errors, that can have a bigger impact on your portfolio than you might think. Therefore, it’s crucial to carefully select ETFs, understanding their composition, management style, and alignment with your long-term investment objectives.
ETFs can be very useful, but only if you know how to use them. Always ask yourself, ‘Am I buying this because it’s right for me or just because it’s popular?’ before you buy it. Your answer could change the course of your financial future.
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