A Booming Business
The introduction of Exchange Traded Funds (ETFs) has been one of the most important developments in the investment industry over the last 15 - 20 years. ETFs have allowed investors to gain access to large portions of the investment landscape even with very small amounts of money. And, just as important, all this is possible at a minimal cost to investors. The growth of the ETF industry, both in terms of total assets and the number of ETFs available has been nothing short of spectacular. At the end of 2023, the total market for ETFs in the United States amounted to $8.1 trillion, and there were more than 3,100 ETFs domiciled in the U.S. (Source: Investment Company Institute).
New ETFs continue to enter the market on a monthly basis, as the providers of these funds attempt to introduce new ‘flavors’ to entice investors. While some of these innovative products may genuinely provide investors with beneficial qualities, many do not. The following is an outline of the groups of ETFs that should be considered carefully, as they may not be suitable for investors whose main objective is long term capital appreciation.
Sector-based ETFs
As the name implies, sector-based ETFs are ETFs that focus on specific sectors or industries. These ETFs are often very concentrated and invest in a relatively small number of stocks. These stocks will tend to move in the same direction in both good times and bad times. That’s fine when that particular sector is performing well. But all industries go through downturns, so when that sector is going through a more difficult period, such a specific ETF is likely to underperform the broader market. Investors should be aware that because these funds come with higher fees, they are unlikely to lead to better performance over the long term. Some examples in this group are ETFs that are focused on the electrical vehicle industry or cannabis stocks.
Illiquid ETFs
When investors see that a specific group of stocks is performing well, they often want exposure to that area of the market. ETF providers are more than happy to oblige and will often introduce new ETFs to take advantage of this trend. Initially, there may be interest in these funds. But over time, the interest in these ETFs may begin to fade. This leaves them with a relatively low level of assets and makes them harder to sell for those invested in the fund. This is a problem of liquidity, and often forces investors to sell the ETF at a discount. Some ETFs that invest in the more obscure areas of the fixed income market or those that invest in certain emerging markets fall into this category.
Leveraged and Inverse ETFs
This group of ETFs is particularly risky, as investors often don’t understand how they function or the increased risk baked into them. These ETFs are designed to magnify, or provide the inverse returns, of a particular index. So, for example, if an investor is very bullish on how the NASDAQ will perform, they may contemplate one of these leveraged ETFs. The expectation is to achieve double or triple the gain that they would typically see from an ETF that is designed to replicate the performance of the NASDAQ. However, these funds often don’t provide the returns that investors expect due to tracking errors. Given the risks associated with these ETFs, they are clearly not suitable for most investors.
ETFs with Higher Fees
As mentioned above, ETFs were originally introduced to offer investors exposure to broad sections of the stock market at a lower cost. This low cost highlights the appeal of these ETFs. However, over time, providers of ETFs have introduced more funds (such as those outlined above) that come with higher management expense ratios. The proliferation of funds only makes investing more complicated for individuals that are not well-versed in the investment industry. Perhaps it is the ‘fear of missing out’ (FOMO) that drives investors to these more exotic funds, when, in fact, most would be better off with the plain vanilla variety. Investors need to be aware that this difference in fees has a huge impact on performance over the long term.
Some Investors Are Looking for More Adventure…
Clearly, it is not possible to mention all the different types of ETFs that are currently available to U.S. investors and the merits and drawbacks of each. Some of these funds may have a place in investors’ portfolios. Also, some investors are more knowledgeable and may be quite comfortable investing in some of the more non-conventional ETFs. This may be more of a tactical investment rather than a long term holding.
…But Most Just Want Peace of Mind
Still, most non-seasoned investors are likely better off with a portfolio built around the broader, more diversified segments of the equity and bond markets. FutureMoney simplifies the investment process by adhering to the basic principles mentioned above. For starters, we invest in a portfolio of funds that is especially designed for long term growth, as opposed to those that happen to be ‘in fashion’ at a certain point in time. We also avoid funds that are particularly risky, which can see a substantial loss in their value with little chance of recovery over time. Finally, we stick to the low cost funds that are most likely to lead to higher returns in the long term.
