In recent times, most investors built their portfolios mostly with mutual funds. Today, Exchange Traded Funds (ETFs) are increasingly popular due to their comparatively lower costs, ease of trading, and transparency. Designed as a simple way of investing that provides solutions for the masses, ETFs are the easy choice for many investors. However, ETFs are not without risk. Like any investment, they need to be monitored, managed, and part of a strategy that provides advice.
Here are three considerations you should take into account:
When everyone sells, it can create chaos.
Remember the stock market melt down of 2015? There has been credible speculation that ETFs can exacerbate flash crashes because, just as it is easy to buy an ETF that tracks the S&P 500, for example, it is easy to sell it. With ETFs sold on an exchange, as opposed to mutual funds, which only trade after the markets close, sell-offs have the potential to be quicker and broader. For this reason, your financial professional must be highly skilled with respect to behavioral finance, so as to guide you through what may ultimately just be a temporary blip in the radar.
Your portfolio requires ongoing upkeep.
Just as with mutual funds, portfolio drift can have consequential affects on the inherent risk in your portfolio. This often occurs when there is outweighed performance on either the upside or downside of a particular security or sector, and results in portfolio distortions. These distortions affect your model portfolio allocation and can create a conflict with your risk tolerance. Thankfully, much of this can be mitigated now with technology that automatically rebalances your portfolio on a periodic basis. We think this allows investors to focus on their strategy, not the tactical implementation.
ETFs are diversified. Your portfolio might not be.
We think that ETFs represent a drastic step forward for most investors because they represent inexpensive diversification that allows for transparency into ones holdings. However, just how diversified is your portfolio? In aggregate, your portfolio may have unintended biases even if it is composed of a bunch of ETFs. Again, this can be quite risky. Fortunately, technology can mitigate this issue as well, so as to emphasize your overall goals within the context of your portfolio, not the individual holdings.
We think that ETFs are a valuable input for most investors as it relates to portfolio construction. But we feel that they are often marketed in a way that does not properly account for the risk that they can introduce. Fortunately, much of this risk can be accounted for with the right financial professional and the underlying use of technology to support the portfolio implementation process.