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Common mistakes with ETFs

January 09, 2021

Equity Traded Funds or ETFs and for the sake of this article, ETNs and index funds, have become very popular in the last 15 years. (I will refer to Index Funds, ETNs and ETFs as ETFs for the rest of the article) How far you might ask? In 2002 there were approximately 117 such funds in existence.[i] As of writing this article in August 2017, there are now over 2041 such funds in existence.[ii] Think about that… there are over 19 times more options today compared to fifteen years ago.

And you thought there were too many new beer & wine options at the local liquor store to choose from. So which ETFs are the best for your investment strategy? Wait, before we answer that question; do you even know what your ETFs do compared to all the other ETFs? When you get a moment run a few 5 or 10 year charts on Google Finance, Morningstar or Yahoo Finance comparing ETFs that appear to be matching the same index or doing the same thing and your confusion will start compounding. You will see a difference in returns. Then read though their prospectuses. You will notice nuances in the language used to describe how they invest your money, some small, some widely different.

Why are their returns different? Dig a little deeper you might see how the fund operates is different than another fund. The annual expense ratio is different, the turnover ratio is different and how much of the fund is allocated to each position is different. The tax consequences of one ETF will be different than another ETF. While you might not see much difference in funds seeking to match or emulate the S&P 500, you will see a big difference in ETFs focusing on other asset classes. (Small Cap, Mid-Cap, International, Emerging Markets, Sector Focused, Corporate Bonds, Municipal Bonds, Preferred Stocks, Master Limited Partnerships, Real Estate, Commodities, Convertible Bonds, etc.)

Passive investing has come a long way, and has provided a valid means of investing for decades. However, with the number of securities publicly trading is in decline, passive investing could have several big challenges ahead. [iii] First, a few big players in the market place own large percentages of publicly traded companies. Unlike active fund managers, activist investors or other engaged investors, ETFs are not known for “getting involved” in company management. You know those letters you get in the mail to vote for board members? ETFs are not known for filling those out in detail either.

I know what you are thinking, does that really matter? Well if a particular company by way of its ETFs is the largest shareholder of a company or companies, and they forgo being engaged in management selection what do you think will be the consequences? If they forgo going against or with management, abstain from voting or are otherwise “passive” I have to believe it will have an impact on firm management and at some point company performance. How much will this impact a company’s ability to generate a return (good or bad)? I have no idea. I’m also curious if this could create a small liability for ETF companies in the future?

Another observation about ETFs is there are hidden costs. Yes, there are several studies that have found hidden costs in ETFs that match indexes. Tracking errors by the ETF administrator and traders with advanced algorithms could be driving up the acquisition cost of the assets in your ETF by 0.20% - 0.85% per year.[iv] [v] Additionally, your ETF or Index Fund might be sampling an index and not actually matching the index with all securities in the index. This could lead to returns that fail to match the index.

There are few truly “free lunches” in life. Let alone saving and investing. Moving forward, investors would be wise to think twice before finding great comfort in investment vehicles that are perceived to be “cheap”. In an effort to keep it simple and complete on price ETFs now control a larger percentage of assets under management than they did 15 years ago. I expect this trend will continue. Markets can be complex, unforgiving and complicated. The ability to access raw information today is impressive and arguably, overwhelming. Where lack of information might have caused consumers to hesitate in the past, today an overload of information can be just as or more debilitating. So what should you do with the thousands of investment options available?

1) I would recommend learning how to conduct due diligence on each of your investment holdings. You need to know what you own and have realistic expectations. (ETFs, individual securities, mutual funds, etc.) Read all of the prospectuses and 10K reports you get in the mail for your investments.

2) Develop an investment policy statement that can answer the following questions: What assets are you going to invest in? When do you buy? When do you sell? What do my investments need to do to meet my goals? When do I need to access my investments? What is my capacity for risk? How much of my assets should I have invested?

If you don’t have time, hire a professional money manager and financial advisor who can do it for you.

Kit Lancaster is a Financial Advisor and Certified Financial Planner Professional (CFP) from Chicago, IL. He enjoys working with young professionals, families and business owners who have a desire to be financially successful and desire courses of action, education and perspective to aid them in accomplishing their financial goals. Kit holds regular educational events in Chicago and online

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Kit is a Registered Representative and Investment Advisor Representative. Trk # is 1881988 and dofu is 8/2017.

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