First, Consider These 4 ETF Disadvantages

There’s no denying that ETFs, or Exchange Traded Funds, have revolutionized the world of investing and made it cheaper, easier, and safer than before. While the advantages of ETFs are many, there are also some sinister disadvantages to ETFs that can creep up on unsuspecting investors.

ETFs are essentially baskets of stocks. One popular ETF is SPY, which tracks the S&P 500 index and buys a basket of stocks to mimic the performance of the S&P 500. Investors can buy the ETF index rather than having to go out and buy every single stock in order to attain a performance to match the market.

ETFs come in all shapes and sizes, and you can buy an ETF based on themes (such as cannabis or biotech stocks), styles (such as a basket of value stocks or high yield stocks), or even an ETF that is managed by an individual (like the ARKK funds). There’s even ETFs to hold commodity contracts such as crude oil, and now there are talks about various ETFs to hold Bitcoin.

Some pros to ETFs include:

  1. Diversification.
  2. Liquidity (easy to buy or sell).
  3. Generally low fees (compared to mutual funds).
  4. Easy for filling gaps in asset allocation.

Some disadvantages to ETFs, which might be controversial, include:

  • Maybe too easy to use, making investors passive.
  • Over-diversification putting a ceiling on returns.
  • Can be misleading (like the fiasco with the temporarily negative oil futures and its affect on the Crude Oil ETF).
  • An industry ETF might not fully represent an industry, and the overall individual stock weightings could be at the discretion of the fund manager.

Let’s start on the over-diversification front. The benefits of diversification can also be a downfall; too much of a good thing can be a bad thing.

Diversification vs Over-Diversification

When a portfolio has adequate diversification, it attains protection against worst case scenarios—such as a stock in the portfolio going bankrupt. For example, say we manage a portfolio with pretty standard diversification. Let’s say there were 20 stocks and each stock was equally weighted, and so each position made up 5% of the total portfolio.

In the position of a worst case scenario or a stock going bankrupt and losing all value to an investor, the overall hit to the portfolio is limited to the total weighting within the portfolio. With 5% position sizes, you’d be looking at a -5% cut, which isn’t ideal but is also not crippling.

Contrast that to a stock that makes up 20%, 30%, or even 40% or more of a portfolio, and you have a much different situation from a failing investment and its potential impacts to your portfolio. While it’s easy for us to play armchair quarterback and think that buying a stock that turns into a huge loss “can’t possibly happen to us,” play the game long enough and you’ll realize that everyone makes a mistake eventually. No stock or stock strategy is perfect.

And so, we keep diversification as a valuable tool to thwart huge portfolio drawdowns, which cripple long-term compounding and investor return. What about overdoing it on the diversification?

Let’s say we took this to the opposite extreme and bought so many stocks that each made up a small part of the portfolio. If we had a stock with a 0.1% weighting, as an example, it could smash it out of the park as a 10-bagger and still only impact the portfolio with a 1% gain. At that point, there’s no real reason to spend time looking at the actual stocks in an ETF as they all don’t move the portfolio that much.

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Disclosure: The author doesn't hold any securities that may be listed.

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