waiting period: A possible disadvantage with ETFs is that, like stocks, you have a three-day settlement process when selling shares. So, for example, if you sell shares of an ETF on Monday, you won’t have the proceeds to invest into a regular mutual fund until Thursday. (This delay won’t be a problem if you’re going back into another ETF or buying a stock, because a purchase order placed on Monday for a new investment won’t settle until Thursday.) If you’re out of the market for several days, the market price can move significantly higher, wiping out any supposed savings from a low-expense ratio.
Potential fees for dividend and capital gain reinvestments: With a traditional mutual fund, you can, without cost, reinvest dividend and capital gains distributions into more shares of the fund. However, with an ETF, you may have to pay for this service through some brokers, or it may not be available through the broker that you use.
Disproportionate amount of particular stocks: One problem with a number of the indexes that ETFs track (and with some index funds) is that certain stocks make up a disproportionately large share of a particular index. This is especially true of industry-focused ETFs. This is also true for some broader market ETFs like those that track the Standard & Poor’s 500 index because each of the 500 stocks’ composition in the index is driven by each stock’s portion of total market value. Check out Table 5-1, which shows the composition of the index at the end of 1999. This list mostly represented a who’s who of many overpriced technology stocks that subsequently got clobbered in the early 2000s bear market.
Invested segments too narrow: Many of the newer ETFs invest in narrow segments, such as one specific industry or one foreign country. As with sector mutual funds (see Chapter 13), such funds undermine the diversification value of fund investing and tend to have relatively high fees. Morningstar, an investment research company, says, “ETFs offer new opportunities to sap returns by racking up transaction costs and/or chasing short-term trends.”
Excessive risks and costs with leverage: Some ETF issuers have come out with riskier and more costly ETFs. One particular class of ETFs I especially dislike is so-called leveraged ETFs. What these ETFs purport to do is magnify the move of a particular index — for example, the Standard & Poor’s 500 stock index — by double or triple. So a double-leveraged S&P 500 ETF is supposed to increase by 10 percent for every 5 percent increase in the S&P 500 index. Inverse leveraged ETFs are supposed to move in the opposite direction of a given index. So, for example, a double-leveraged inverse S&P 500 ETF is supposed to increase by 10 percent for every 5 percent decrease in the S&P 500 index.My investigations of whether the leveraged ETFs actually deliver on their objectives show that they don’t, not even close. For example, in the two-year period ending in early 2010, one double-inverse S&P 500 ETF (brought to my attention by a reader who owned it and asked me about it) fell by 43 percent, a period during which one would have expected to have increased about 28 percent because the S&P 500 index actually fell by 14 percent.
TABLE 5-1 The Companies of the Standard & Poor’s 500 Index at the End of 1999
| Stock | Rank in Index | Market Value | Percent of Index |
|---|---|---|---|
| Microsoft Corp | 1 | $604,078 | 4.92% |
| General Electric | 2 | $507,734 | 4.14% |
| Cisco Systems | 3 | $366,481 | 2.99% |
| Walmart Stores | 4 | $307,843 | 2.51% |
| Exxon Mobil | 5 | $278,218 | 2.27% |
| Intel Corp | 6 | $274,998 | 2.24% |
| Lucent Technologies | 7 | $234,982 | 1.91% |
| IBM | 8 | $194,447 | 1.58% |
| Citigroup Inc. | 9 | $187,734 | 1.53% |
| America Online | 10 | $169,606 | 1.38% |
Seeing the pros and cons of trading ETFs
One supposed advantage of trading ETFs is that, unlike the regular index mutual funds I recommend in this book, you can trade (buy or sell) ETFs throughout the weekdays when the stock market is open. When you buy or sell an index mutual fund, your transaction occurs at the closing price on the day that you place the trade (if the trade is placed before the market closes).
Timing your moves in and out of the stocks: Being able to trade in and out of an ETF during the trading day isn’t a necessity, nor is it even a good practice. In my experience of working with individual investors, most people find it both nerve-racking and futile to try to time their moves in and out of stocks with the inevitable fluctuations that take place during the trading day. In theory, traders want to believe that they can buy at relatively low prices and sell at relatively high prices, but that’s far easier said than done.
Paying a brokerage commission every time you buy or sell shares: With no-load index funds, you generally don’t pay fees to buy and sell. But with ETFs, because you’re actually placing a trade on a stock exchange, you pay a brokerage commission every time you trade through some brokers. For example, if you buy an ETF with a seemingly low expense ratio of 0.1 percent and you pay $10 to trade the ETF through an online broker, that’s equal to paying two years’ worth of management fees if you invest $5,000 in the ETF!
Figuring out whether the current price on an ETF is above or below the actual value of the securities it holds: Because ETFs fluctuate in price based on supply and demand, when placing a trade during the trading day, you may face the uncertainty and complication of trying to determine (if you care) whether the current price on an ETF is above or below the actual value of the securities it holds. With an index fund, you know that the price at which your trade was executed equals the exact market value of the securities it holds.
