Disadvantages of ETF investment

Disadvantages of ETF investment

We will talk about the disadvantages of ETF investment. The ETF discussed in this article refers to all stock ETFs; it is not limited to ETFs that track the broader market. For ETFs introduction and overview, I had a post Most investors should invest ETFs tracking broader market. Interested readers, please read this article of mine first.

Holding cost

Regardless of the ETF, regardless of the stock market in any country, a certain percentage of the annual custody fee needs to be paid every year. Few people treat ETFs as short-term stock speculations, and they generally hold them for a long time (otherwise it is difficult to make a considerable amount of money); therefore, the annual custody fee is the main holding cost. The custody fee cannot be zero, because ETF issuers need to buy and sell stocks at any time according to the price of each constituent stock, and adjust the proportion of portfolio holdings.

But don’t forget that in the stock market outside the United States, buying and selling ETFs is the same as buying and selling general stocks. You need to pay transaction fees. This is not a small amount of money and needs to be taken into consideration.

In comparison. In the case of U.S. stocks, unless you hold ADR stocks of non-U.S. companies listed on U.S. stocks, there is no holding fee at all. Moreover, the transaction fees for trading in US stocks have long since been zero.

Limited rate of return

As I wrote in my post Why concentrated investment?” when the number of members in the investment portfolio increases, the price fluctuations of the investment portfolio will be reduced; this is what most people call diversified investment risks. The number of stocks in the ETF portfolio, generally speaking, must exceed 5 to 7, which has been able to fully diversify the risk of the investment portfolio. Of course, the advantage is to reduce volatility, but the disadvantage is to reduce the volatility of stock prices-as a result, it is impossible to obtain better returns. In the vernacular, this is a necessary evil to diversify investment risks.

For an ETF that tracks the S&P 500, which represents the U.S. stock market, the annualized rate of return for the past 25 years is 7.51%. It is indeed only a single-digit return, and it takes 9.57 years for the value of your investment portfolio to double.

But investors should not forget that this is a basic issue of selectivity. Investors who invest in ETFs already know ETF return should be less than the individual stock. In addition, this kind of compensation can not only defeat 79% of professional equity fund managers, but also surely allow you to defeat inflation. I will not repeat these here, please refer to my blog my previous article about ETFs.

No flexibility

Since an ETF is composed of many stocks, it is equivalent to a portfolio of a basket of stocks. The constituent stock members in the ETF portfolio are fixed and must be disclosed to investors in advance, and cannot be changed daily or at any time. To replace the constituent stock members, issuers have certain internal and external work flows to run away. Even if the issuer wants to replace the constituent stocks, it is too late and cannot be reflected immediately.

Unqualified composite stocks

There are many ETF issuers for various reasons that they will not tell you (investors should not assume that wealth managers are very professional and conscientious), when choosing a portfolio of ETF stocks, they will be more or less intentional. Or inadvertently (often intentionally and unprofessional) choose stocks that are simply irrelevant or underperforming. But because it’s ETF you bought, you couldn’t say no, you were forced to accept the stocks that dragged down the overall performance.

I often give an example. There is an electric vehicle ETF issued by a well-known issuer in Taiwan. There is China Steel in it, and several foreign electronics stocks are listed, but there is no Texas Instruments (ticker: TXN), an important manufacturer of automotive chips); the businessman replied that because electric vehicles are also vehicles, steel is needed; as for the absence of Texas Instruments, he can’t answer (I guess he should have no relevant industry knowledge). That’s one of the main reasons why I don’t recommend investors investing in ETFs except tracking broad market. Please see article “How does Texas Instruments make money? Amazing long term capital reward and company net profit margin!

Boring

John Train said that “Investment is the craft of the specific.” Investment itself is a matter of attention to detail, high repetitiveness, and boring, not a matter for you to have fun. Remember what Buffett said, “many of our successful investments can be attributed to inactive investment behavior; most investors are unable to resist the temptation to keep buying and selling.”

Time needed

Since ETFs are also stocks, because ETFs are composed of multiple stocks, the risk of volatility will be much lower, and the rise of ETFs will be much smaller than that of individual stocks. Investing in stocks takes a long time to pay off, let alone ETFs. If you want to make short-term profits, are impatient, or treat ETFs as individual stock speculators, it is recommended not to invest in ETFs. Because the investment advantage of ETFs and stocks lies in long-term compound interest, it is recommended to hold ETFs for at least 10 years. In fact, it is difficult to see its power if less than 5 years.

Disadvantages of ETF investment
credit: Disadvantages of ETF investment

Investors’ myopia

ETF investors are especially reminded that in the past three years (2019 to 2021), whether it is Taiwan stocks or U.S. stocks, the annual return rate of 20% is an extremely exceptional situation. As a result, many people flock to the ETFs tracking broad market . If you have a hard time agreeing with the fact that ETFs tracking broad market should look at annualized returns over 10 years, I would advise you to think otherwise and not consider investing in any ETFs tracking broad market. Because:

  • The annualized rate of return of the Taiwan stock market index ETF over the past 26 years is 8.09%, the annualized rate of return of the S&P 500 index ETF representing the U.S. stock market over the past 26 years is 8.2%.
  • Even from 2001 to the end of 2010, the annualized return of the S&P 500 in the U.S. stock market was negative 0.49%; but from 2011 to 2020, it was a rare bull market in the history of U.S. stocks, and the annualized return of the S&P 500 was as high as 11.56%.
  • If you stretch the time longer, the annualized returns of ETF tracking the broad market will be slightly lower; this is because the past thirteen years have been caused by the rare bull market in global stock markets.

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