Getting Started With ETFs

February 24, 2022

Disadvantages of ETFs

Trading Costs
The ability to trade ETFs throughout the day is great, but it often doesn’t come for free. Investors don’t buy or sell ETFs directly from ETF providers or sponsors, but instead, purchase them in the secondary market via an exchange accessed through a brokerage firm. Accordingly, investors may be required to pay a brokerage fee each time they trade an ETF, similar to purchasing an individual stock. The more you trade, the more you pay.

Several brokerage firms have started offering some or all ETFs with zero transaction fees, which can be a cost factor depending on the size and frequency of transactions.

Bid/Ask Spread
Beyond commission fees on trading, the bid/ask spread is another important cost consideration. This spread is the difference between the price being bid (what you pay) and the price being offered (what you sell it for) for shares of the ETF being traded on the exchange.

Bid/ask spreads tend to reflect the weighted average of bid and ask sides for each of the component holdings within the ETF. ETFs representing more thinly traded segments of the market can, consequently, be expected to exhibit wider bid/ask spreads. ETFs with relatively low trading volumes also generally have wider bid/ask spreads than ETFs that are more heavily traded.

One rule of thumb that applies here is that, typically, the wider the spread, the more it can cost you to trade an ETF.

Premiums/Discounts
ETFs are designed to trade as closely as possible to their net asset value throughout the day—the fair value of their underlying holdings. But sometimes, especially in fast-moving markets, premiums and/or discounts can develop, resulting in potential losses to investors. That’s not the case in mutual funds, which can only be bought and sold once a day, at the end of the trading day, and always at net asset value.

Tracking Error
Tracking error is a performance metric that also relates to the cost of owning an ETF. This error represents the difference between the returns of the ETF and the performance of the index it’s supposed to track. Tracking error tends to be lower for heavily traded ETFs and ETFs that represent heavily traded securities. The four most common reasons tracking errors occur are:

Expense ratio – An ETF’s expense ratio is taken directly out of net returns. The expense ratio is the sum of all the expenses of the ETF divided by its assets. Internal costs associated with running the fund—including management fees and/or acquired funds’ fees—go into this cost metric. Naturally, the higher the expense ratio, the larger the tracking error.

Diversification Rules – The Securities and Exchange Commission imposes strict diversification rules on ETFs, including one prohibiting an ETF from holding a single security comprising more than 25% of the ETF. For specialized or specific ETFs, at times, this can make it difficult for an ETF to track its index.

Optimization Techniques – Some funds will buy only a subset of stocks that are in the underlying index in an attempt to provide performance similar to the index. “Optimization” might be used when full replication of an index is not possible (e.g., limitation on position concentration or position size, a limited number of shares available on one or more index components). This technique might also be used to lower trading costs. The degree of optimization can affect the size of the tracking error.

Dividend Drag – This occurs when there is cash in a fund. Since no major index is constructed with a cash component, when a dividend is paid on shares inside an ETF, there is a lag between receiving and reinvesting the cash. This error is generally very minimal, but it could potentially be a source of tracking error.

To contrast, mutual funds have all of these reasons for tracking error as well, but may have even higher odds of departing from their stated benchmark performance because they often have higher management fees. Mutual funds also are more likely to have cash drag, as they need cash on hand for redemptions in addition to the cash from dividend drag.

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