ETF often incur trading costs like commissions, can be complex due to diverse types and strategies, and usually provide limited exposure to small-cap stocks.
Trading Costs
When you invest in ETFs (Exchange Traded Funds), you should consider the transaction costs of buying and selling shares. As we all know, ETFs can be traded throughout the day, while mutual funds are only priced once at the end of the trading day. This trading freedom comes with additional costs.
Brokerage Commissions
When you buy and sell ETFs, you may pay a commission each time you buy or sell an ETF, unless the brokerage firm you use offers free ETF purchases. These fees vary and are affected by the brokerage firm involved in the transaction, the platform used to facilitate the transaction, and the details of the transaction. All of these fees can add up to a significant amount, especially for active traders who often have single-digit profits. A brokerage firm charging $5 per trade would generate $100 in commissions for buying and selling an ETF ten times per year.
Bid-ask spreads
The bid-ask spread is another inherent cost of trading ETFs. This is the difference between the highest price a buyer is willing to pay (the bid price) and the lowest price a seller is willing to sell (the ask price). For example, a so-called popular ETF may have a spread of a few cents, while a less traded ETF may have a spread of a few dollars. This may change the effective price at which you trade the ETF, especially during periods of market volatility.
Impact of Market Conditions
Market conditions may further exacerbate trading costs. When volatility is high, spreads are often wider, which can be expensive to trade. This approach is particularly interesting in fast-moving markets, where the costs of opening or closing a position can be very high.
Complexity
ETFs (Exchange Traded Funds) are probably one of the most complex investments an investor may come across due to their structure, the wide variety of types and more importantly the strategies these ETFs employ, which is why it can be an overwhelming choice for someone new to the financial markets.
Types of ETF
There are many ETFs, thousands in fact. There are thousands of ETFs on the market covering everything from broad market indices to specific niches such as emerging markets, specific sectors, commodities or leveraged or inverse trading strategies. For example, an investor chooses to invest in technology, which may involve choosing between a general technology ETF, a semiconductor ETF or even a narrower ETF such as a cybersecurity or artificial intelligence ETF.
Underlying Assets Explained
Thus far in this journey, each ETF will use its own methodology to track an index or achieve a specific investment outcome, including the potential to hold underlying assets or apply derivatives such as futures and swaps. The move to use these financial instruments makes things very complicated as it requires an understanding of their impact on fund performance and risk.
Tax Considerations
The taxation of ETFs is also somewhat complex. ETFs are generally more tax efficient than mutual funds due to their structure, but can also cause tax issues, particularly if they invest in commodities or use certain strategies that involve frequent trading. These may have different tax treatments, for example it may be taxed as a collectible, or the interest is treated as income rather than dividends and capital gains.
Tracking Error
Complexity also includes tracking error, which is the difference between an ETF’s performance and its underlying index. Transaction costs, management fees, and the way index exposure is achieved are all possible reasons for this difference. Investors should pay close attention to this to ensure that the ETF is meeting their intended investment objectives.
Limited Exposure to Small Caps
One major drawback shared by many ETFs is the partial or total exclusion of small-cap stocks from the portfolio. Small-cap stocks – Small-cap stocks, i.e. stocks of companies with market capitalizations between $300 million and $2 billion, are expected to achieve significant growth, but many traditional ETFs lack exposure to these securities.
Focus on larger indices
Traditionally, the most popular ETFs aim to replicate indices such as the S&P 500 or the Nasdaq 100, which are primarily composed of mid-cap and large-cap entities. The S&P 500 is another example; while small enough to qualify as small-cap by some criteria, the smallest companies in the S&P 500 still have market capitalizations that exceed the traditional small-cap threshold, thus still excluding other smaller companies that may have high growth potential.
Risk-averse
Providers of exchange-traded funds often target large companies because they tend to be more complete and easier to sell, and therefore more attractive to conservative investors. However, due to risk-averse policies, ETFs are more likely to lose money or underperform when it comes to smaller, more nimble businesses. Historically, small-cap stocks have significantly outperformed large-cap stocks during certain periods of economic recovery.
Market Dynamics
Small-cap stocks respond to market stimuli differently than large-cap stocks. They are often more correlated to changes in the domestic economy, so they are an important part of a diversified portfolio seeking growth opportunities. But major ETFs don’t always include these stocks to track the market, which means investors may not be able to use these dynamics to their advantage.
Small-Cap ETF Access
While small-cap ETFs exist, there are fewer of them than large-cap ETFs, and these funds tend to have higher expense ratios because small-cap stocks are smaller and less liquid, which makes managing a small-cap portfolio more expensive. Additionally, these small-cap-focused ETFs may not cover the entire small-cap market and may focus only on the most liquid or largest small-cap stocks, an approach that can hurt true small-cap investing.
