The popularity of index-fund investing has never been higher. In fact, one could say they are all the rage of Wall Street and Mainstreet. However, there are some critical downsides to this investing approach that lie obscured just beneath the surface—drawbacks that you should understand and carefully consider. In this article, we’ll explore 8 not so obvious downsides to ETF investing.
Simply put, an index-fund, or exchange-traded fund (ETF), is simply a basket of securities intended to track a market or market segment. A popular example is the SPDR S&P 500 Trust ETF (affectionately known as the Spider).
To be clear from the onset, I’m NOT saying ETFs are bad! To the contrary, they have clear benefits:
I say better because there are inherent (albeit less visible) downsides to investing via these popular financial instruments. We’ll examine 8 big ones in this article:
Let’s dive in and explore the not so pretty side of index-fund investing…
The first downside to index-fund investing is that ETFs are inherently inflexible. You get a basket of stocks and you are stuck with that basket.
This drastically limits your ability to capitalize on opportunity.
There are three primary drivers with investing: market dynamics, sector/industry dynamics, and company dynamics.
Index-funds, by nature, are broad—they are designed to cover (or track) a wide market or market segment. As such, you can’t capitalize on sector/industry or company dynamics.
With ETFs, it’s all or nothing—you are going to go where the aggregate market goes. You bought a tracker… it’s going to track.
You do have an option to diversify into sector or industry ETFs; however, these may have higher costs and/or less liquidity… and it simply begins to add the very complexity that you were likely trying to avoid when choosing to index-fund invest.
The second downside to index-fund investing is that, in order to be passive, ETFs must have a simple investing process that can be automated. To accomplish this, they are typically capitalization-based.
Simply put, this means if Company ABC represents 10% of the market capitalization in the market being tracked, then it will represent 10% of the ETF’s basket. As that capitalization margin changes, so will its size in the ETF.
In other words, as a stock becomes overvalued (share price rises)… its market cap increases—as does its allocation in the index-fund. Likewise, as a stock becomes undervalued… its market cap decreases—as does its allocation in the index-fund.
This means you are buying progressively more of the overvalued stocks and progressively less of the undervalued ones. The exact opposite of what you want to be doing! It has been estimated that cap-weighted funds cost you 2-4% of potential annual return due to this skew.
An alternative option is to invest in equal-weight ETFs. They are absolutely a better option—one that will potentially allow you to recapture a portion of those returns you left on the table above. However, you are still (1) buying the good with the bad and (2) buying under and overvalued assets… just equally!
Simply put, ETFs do not provide an effective mechanism for capturing value. And an equally concerning corollary to this is that you have zero margin of safety at any given point in time. Best-case scenario (with an equal-weight ETF), your undervalued holdings are offset by the overvalued ones… and worst-case scenario (with a cap-weighted one), the overvalued holdings will far outweigh the undervalued ones.
Let’s face it, there is no way to perform a valuation or fundamental analysis on an ETF.
This fact contributes to the passivity of this investment strategy; however, it also represents the third downside to index-fund investing: It greatly reduces your opportunity to grow as an investor.
While this is one of the most basic (and brief) drawbacks, it is, nonetheless, one of the most profound.
Every day you limit yourself to index-funds, you are missing out on the opportunity that time in the market (experience) provides to learn and grow!
It is important that—as your wealth grows—your investing knowledge, skills and abilities grow as well. With ETFs, you develop stunted financial growth! You fail to develop skills like valuation, fundamental analysis, portfolio allocation management, risk management, and so many other facets that may become critically important to you down the road.
The fourth downside to index-fund investing is their volatility.
Index-funds tend to have elevated levels of volatility. They are notorious for having the worst and longest-lasting drawdowns of just about any investing strategy out there–hence the development of traditional blend approaches that reduce your exposure to equities over time (e.g., the classic 60/40 equity-bond blend).
And, with ETFs, you have no mechanism to smooth or limit this volatility (beyond adding a bond fund)… you just have to buckle up and enjoy the ride. (And when that ride turns into a plunge… it’s not too enjoyable)
Here’s a ranking of 18 portfolio strategies from Portfolio Charts:
As you can clearly see, a total stock market portfolio (like the SPY ETF represents) is ranked dead last in every category but two—and one of those it is second to dead last. Now yes, it ranks number one for average return… but (1) you would have to stomach massive and lengthy drawdowns and (2) the delta in that average return verses the rest is not that significant—certainly not worth that colossal volatility (you better have a very, very long investing time-horizon!).
Here’s how that would look on a risk vs average return basis (again, from Portfolio Charts):
As you can see, broad ETFs can cause you to take on massive risk for only a slight gain in average return!
And that volatility can kill you over the long run. Here’s one last chart from Portfolio Charts that shows what the risk vs baseline long-term return looks like for a total stock market (i.e., ETF) portfolio:
You wind-up with the lowest long-term baseline return of all 18 portfolio strategies… for massively more risk (volatility)! This approach goes from first (average return by a hair) to worst (baseline LT return)—and is the undisputed risk-adjusted loser of all by a Mississippi mile. Not a great overall investing plan!
By managing your own portfolio, you can mitigate risk and reduce your volatility (deviation).
This is critical because gains and losses are not created equal! That’s why the first rule of investing is don’t lose money!
If you can limit your downside risk (volatility)—even if you have to sacrifice a little upside potential, you are better off.
Don’t believe me?
Let’s say you invest $100 in an ETF and said ETF drops 25%. You now have $75. You may think that you only need a 25% gain to get back to even… but you would be wrong.
Doing the math, you would actually need a subsequent gain of 33.3% to get back to $100!
Let’s take this one step further…
Let’s say that instead of a 25% drop, you were able to limit your downside to 15%; however, you would have to also limit your upside gain from 25% to just a 15% one as well.
That’s -25%/+25% vs -15%/+15%… think it’s a wash?
Guess again! Remember, losses do not equal gains!
You can play with the numbers on your own, but the point is that limiting your losses (downside) is critical to investing success—even if you have to slightly limit your upside potential. You dampen the volatility in your portfolio and come out ahead in the end.
Unfortunately, ETFs simply don’t provide you with a great mechanism to do that.
(Which is precisely the hidden story the risk-return charts show above!)
The fifth drawback falls under the banner of behavioral finance: index-funds narrow your focus.
ETFs force you to look at a few numbers rather than a broad portfolio of diversified companies. This may be fine and dandy when the markets are up and those couple of numbers are all green. However, it’s a different story when that index volatility kicks-in and all you see is red!
Index-funds make it especially easy to succumb to herding. You pile in big when things are green (usually late in the game and close to the highs) and panic sell low with the herd when everyone is running for the exits. That’s the dark side of higher volatility.
To the contrary, when you manage your own well-diversified portfolio of individual stocks, it is far more likely that at any given point in time some will be up (green) and some will be down (red). This provides you with a balance that is far less emotionally-jolting! This, in turn, makes it far more likely that you (a) won’t develop ulcers and (b) will stay in the game for the long run.
With index-funds, you lack control over your capital. All dividends are reinvested directly into the ETF.
When you manage a portfolio of individual stocks, those streams of cash flow (aka passive income) flow directly to you. You then have complete control over how they are used:
Yes, there are tax implications for these distributions… but those can be easily and effectively managed without surrendering your control.
The next drawback to index-funds is that everybody wins a Trophy.
What’s so bad about everyone getting a trophy you ask?
It means you absolutely cannot outperform with an ETF.
I don’t know about you, but I hate two words: average and mediocrity. I’m a performance-driven person and I thrive on the opportunity to outperform.
I’m willing to risk not getting a trophy for the opportunity to hoist a really big one!
Remember, with index-funds, you are simply along for the ride. An ETF is going to track… and you are going to go exactly where the market does—no better, no worse.
That can be a good thing (when the market is going higher), but it can suck when the market goes the other way—and remember that index-funds tend to be highly volatile by nature (see Rule #4).
If I’m going to take Mr. Toad’s Wild Ride, I at least want the opportunity for a payoff—some outperformance. But with ETFs, that will never happen.
Remember, even just a little bit of outperformance—when leveraged with time—can make a massive difference in your outcome. Every basis point of alpha means you are closer to your financial goals!
If you’re (a) fine with average or (b) using an ETF as a targeted mechanism to gain exposure or reduce volatility in your broader portfolio, then index-funds may be the right tool. However, as a total investment plan, you have to be willing to accept the ups and downs… all to end up with average results and a little “thanks for participating” trophy at the end of the game.
Finally, the last drawback is simply the fact that not all ETFs are created equal. While they are simple in concept, they can differ greatly in the details… and we all know where the devil lives!
Before selecting an index-fund, ensure you fully understand:
I just want to take a moment to touch on the last two items…
First, liquidity is critical. While large ETFs like the SPY are highly liquid, when you get into smaller ETFs (like those that track sectors, industries, or untraditional asset classes), they can be highly illiquid! This means that when things go wrong and everybody is heading for the exits… it will be a really tight fit if you need to get out as well!
Second, make sure you understand the process. There are exotic ETFs out there that don’t necessarily behave the way you would think. A perfect example of this are inverse (or short) ETFs—they even have 2x and 3x inverse ETFs. The problem is that you can easily lose money even when you think you are making it!
Here’s an example of a $100 initial investment in a 2x Inverse ETF:
Despite the fact that the net change (both in the ETF and the tracked market) was zero, you would have lost a whopping -17.1%!
Here’s another example where the market actually ended up down 5% (which you would think means you made money since it’s an inverse ETF):
Despite the fact that the tracked market ended up down -5% (and you ended up with what might look to be a “net” +10% gain), you would have actually ended up with a -6.7% loss in terms of capital (not factoring in the expense ratio)!
Two lessons: (1) losses and gains are not created equal and (2) understand what you are investing in!
(The first lesson is even more important in a leveraged product!)
The point of this article was not to bash index-fund investing. ETFs offer a number of excellent benefits—under the right circumstances.
However, index-fund investing is not all rainbows and unicorns. It’s not like the E-Trade commercials—you’re not just guaranteed to end up retired on a yacht, surrounded by beautiful ladies (or guys), while you sip champagne!
There are lots of drawbacks to index-fund investing that you need to consider and understand before investing:
If you’re looking for a better way, then you’re in the right place!
We focus exclusively on helping others become as successful as possible with dividend-growth investing and we hope you’ll continue to return to our site to learn, grow, sharpen your skills, and find effective and positive ideas and motivation!
Soak it all in, take and use what you want, modify it to fit your unique situation, and keep building that portfolio with a solid process and winning mindset!
Finally, if you’re interested in starting a dividend-growth portfolio, we highly recommend using M1 Finance (we listed the numerous reasons for this in many of our other articles!).
If you decide to pull the trigger, please consider using our M1 referral link https://mbsy.co/sZVS3 and we’ll both get some free cash!
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