Four Things to Know About the Potential Disadvantages of ETFs

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 which can creep up on unsuspecting investors.

ETFs are essentially baskets of stocks.

One popular ETF is the $SPY, which tracks the S&P 500 index and buys a basket of stocks to mimic the performance of the S&P 500.

ETFs come in all shapes and sizes, and you can buy an ETF based on themes (such as weed or biotech stocks), styles (such as value or high yield stocks), or even an ETF that is managed by an individual (like the ARKK funds) .

There are even ETFs to hold commodity contracts such as Crude Oil, and now there are talks about various ETFs to hold Bitcoin.

ETFs can be great vehicles for investing as they provide:

  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 [Click to Skip Ahead]:

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. If we were to 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 case 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% haircut, which isn’t ideal, but 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; that’s life.

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.

At the end of the day you have to decide what type of risk versus reward you’re happy with.

If you’re happy just matching the S&P 500, or the overall stock market (including the S&P and the Russell 2000 as an example), then over-diversification is actually not a disadvantage but what you really wanted anyway.

It’s for the investors who are trying to beat the market, even if by a small amount, where over-diversification can limit the results– as too many positions mean stock picking isn’t contributing all that much to the final return.

In that case, an investor would have to select a lot of market-beating stocks in order to beat the market, rather than just being able to pick one or two which can carry the entire outperformance of a portfolio in a given span.

Sector/Industry ETFs: Potential Pitfalls

This discussion on portfolio weighting brings us to ETF disadvantage #2—revolving around industry ETFs.

The point of an industry ETF is quite simple, instead of having to buy every stock in an industry, an ETF can do that for you, and you can buy the ETF rather than each stock to get exposure to those returns.

There are several problems with this.

1) Many companies (especially the top technology firms today) are involved in multiple markets and industries and can’t be defined as solely a part of one industry or the other.

Take Amazon as a great example.

Amazon has a huge retail platform through its website that sells anything and everything you can think of. They really are the “everything store,” and compete with the likes of giant retailers like Walmart while doing so completely online (at least that’s how it started).

But, as Amazon has increased its size, it’s also moved to deliver many of its packages on its own or through 3rd party contractors, rather than rely on traditional parcel shippers like UPS or FedEx. In that regard, the shipping portion of the business competes with UPS and FedEx, while Amazon also still competes with giant retailers like Walmart for its products.

That’s not all with Amazon, however. A huge part of Amazon’s operating income, and one that is increasing rapidly, is their Amazon Web Services (AWS) business. AWS provides cloud infrastructure to businesses both big and small, allowing them to host their data and processing power directly in the Amazon ecosystem.

Then you throw in Amazon’s other products into the mix, such as their Prime Video, Kindle, Kindle Fire, and many others… and Amazon’s real industry can’t be defined by one word.

In other words, if you want a piece of the industries in which Amazon competes, you’ll have to own Amazon the stock itself rather than some ETF in cloud, or retail, or media.

The more interconnected the companies in an industry, the harder it becomes to construct an ETF as a “pure-play” on an industry.

2) Another problem with sector/industry ETFs which I’ve seen quite commonly is in the decision making for the companies included into an index and how they are weighted.

Based on the overarching biases of whoever constructed the components of an ETF, an investment in such a vehicle could match what you wanted or wildly miss the mark depending on how it’s constructed.

A perfect example of this was one of the homebuilding ETFs I came across as I was researching the industry back in 2020.

On a day when many homebuilders rose, I saw the ETF rise… not that much. Curious as to what was going on, I saw that the index had heavy weightings on stocks that were related to the “homebuilding theme” but not directly involved—those like Whirlpool (appliances) and Sherwin Williams (paint) who generally prospered during hot housing markets but weren’t pure play homebuilders by any stretch.

In fact, buying any ETF based on a theme requires an investor to really dig deep into how the portfolio is constructed… which brings it’s own set of problems….

Like, how do you know if an ETF is constructed as a “pure-play” unless you know how the businesses inside function? For every direct “pure-play” stock such as a 100% homebuilder, there could be another “Amazon” with a wide range of business segments and revenue streams.

The Low Down on Commodity ETFs

ETFs can be a great way to get exposure to commodities, but the disadvantages to those types of ETFs is that they are not all constructed the same.

Take two commodity ETFs that you would think should be very similar, one for Crude Oil and one for Gold.

The crude oil ETF does not actually hold barrels of crude oil as part of its assets, even though the price tends to move with the price of oil. This is in stark contrast to many gold ETFs, where the funds actually hold physical gold and thus have an actual, tangible claim on the asset that the ETF is representing.

You see, it’s simply not practical to hold barrels of crude oil in order to satisfy enough assets to make a tradable ETF. They are too heavy, storage containers are too big, and the commodity is expensive to transport and store. Gold is much simpler; it can be buried under a mat.

That might sound pedantic to the newer investor, but those implications were huge during 2020 when the price of a crude oil contract temporarily went negative.

Example: When Crude Oil Went Negative

An ETF like one that tracks the price of crude oil must hold futures contracts instead of the actual asset, and in order to maintain orderly liquidity and solvency, must generally hold multiple contracts instead of just one.

But the price of crude oil or other commodity futures which you see quoted all over the place generally refer to the upcoming expiring contract.

In the case when one of the crude oil future contracts expired and went negative, the fund tracking crude had to take steep losses as it was forced to sell out of the contracts in order to swap it for new contracts, as required to meet the prospectus of the fund.

This prevented the ETF from recovering its asset value even though the price of crude oil futures stabilized, which crippled the price of the ETF and caused actual performance to veer from how the commodity itself actually performed.

If that all sounds confusing, that’s because it is.

And it gets back to ETF disadvantage #1, which is where ETFs sometimes make the process too simple, and this can mislead an investor.

Because commodities and other investment vehicles trade on futures contracts, the mechanics behind those prices move and aren’t as synonymous as the price movements of a vanilla stock.

To play on a commodity like Gold or Crude could mean taking on extra market timing risk on top of the risks in drawing your carriage to the commodity itself, which makes the performance of such an ETF to follow its benchmark not exactly a perfect guarantee.

When Too Easy is Not a Good Thing

Finally, you have the possibility that ETFs enable investors to be really lazy with their investments and buy something without much thought.

This can be extremely detrimental particularly because its consequences aren’t felt until much, much later.

When an investor doesn’t have conviction in an investment, there’s usually not too much of a problem because most of the time a stock market is in a bull phase and everyone’s making money together.

The problem happens when an investment turns against you.

It’s at that moment that you have to choose fight or flight, and the conviction of your investment selection rears its ugly head and looks at you right in the face.

If you bought an investment like an ETF because it was easy, then it also becomes very easy to subsequently sell an ETF when the going gets tough, which is the absolute worst time to be selling.

The trouble with the stock market is that it occasionally goes through violent crashes, but… it’s always recovered. And so it might be tempting to think that you’ll be able to time these crashes and recoveries; the reality is that each market period is different and it’s very hard, if not impossible, to get that timing right.

In which case, to be a consistently successful investor you have to stay invested for the long term, to allow your stocks to recover after they’ve encountered some turbulence.

Some of the biggest days of gains happen immediately after a stock crash, but those investors who sell after a crash don’t experience that rebound.

That’s why it’s critically important to know what you own and why you own it.

If you bought an ETF because it was easy, and you thought it tracked an index or theme but that theme did poorly or the ETF did a poor job of tracking, then it might become easier to give up on the investment and take a serious loss.

Do that enough times and you’ll find yourself with REALLY unattractive returns over the long term.

Better to know what you hold and why you hold it, which means rolling up your sleeves and educating yourself on your investments.

The Bottom Line

While I hope this post didn’t discourage you from ETFs if the advantages of them appeal to you, I do hope it’s made you aware of some of the potential pitfalls with ETFs and how they can snag investors if you’re not careful with them.

I’m a loud and proud proponent of buying individual stocks because of the sense of ownership and responsibility it demands of investors, but I also have many friends and colleagues who use ETFs to their advantage and get great results.

But those same people have gone through the hard work of educating themselves about investments, and inherently understand these ETF disadvantages and are mindful of them as they select the ETFs.

As the world of ETFs grows greater and greater, more caution, discipline, and research is required to separate the great ones from the weak ones…. And so don’t skip that part.

Post updated: 1/14/2023

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