Exchange-traded funds (ETFs) are one of the most successful innovations in the recent history of finance. New exchange-traded funds debut constantly in a market that’s grown more than 20% per year over the last 10 years, according to some measures. The industry reached a record $5.44 trillion in assets for the year 2020 after more than $507 billion of ETF inflows for the year.

According to the Financial Planning Association, 85% of advisors use ETFs and recommend them for clients. U.S. equity ETFs alone took in $165.4 billion in inflows in 2020, with most of those funds going into large-cap offerings and big index trackers like the SPDR S&P 500 ETF (SPY).

Key Takeaways

  • Exchange-traded funds (ETFs) have seen enormous growth over the past decades, reaching a record $5.44 trillion in assets in 2020.
  • ETFs are hailed as low-cost, tax-efficient, liquid, and diversified investment vehicles appropriate for all sorts of investors.
  • The rapid and accelerating rise of ETF inflows, however, has left some market experts concerned, leaving open the door perhaps for unappreciated risks on the horizon.

Some ETF Benefits

Investors of all types and motivations have been moving into ETFs, which offer lower-cost diversified portfolios. ETFs capture market share from their mutual fund peers because they offer a way to diversify; they’re inexpensive and tax-efficient. They also offer a high level of liquidity because they trade daily, giving investors the power to move in and out of positions with relative ease. But with great power, as the saying goes, comes great responsibility and the tradability of ETFs can be their greatest liability, experts say.

ETFs provide lower average costs since it would be expensive for an investor to buy all the stocks held in an ETF portfolio individually. Investors only need to execute one transaction to buy and one transaction to sell, which leads to fewer broker commissions since there are only a few trades being done by investors.

Brokers typically charge a commission for each trade. Some brokers even offer no-commission trading on certain low-cost ETFs reducing costs for investors even further. Finally, ETFs tend to be more tax-friendly for investors than an equivalent mutual fund due to the way that distributions and taxable events within the fund portfolio are treated.

Some ETF Risks

Liquidity is supposed to be an unambiguously beneficial feature for an investment product. But if an ETF’s daily liquidity allows retail investors the chance to live out their fantasies of trading like a hedge fund manager, that good characteristic can hurt investment returns in the form of fees, fees, and more fees. 

Experts say that, for most investors, uninterrupted trading is not an advantage since it presents non-professional investors with the temptation to chase alpha. Even professional investors who try to time the market have a notoriously bad track record. The average layperson can be expected to do even worse on average.

Vanguard Group founder Jack Bogle, speaking in 2010 on the “astonishing” trading volumes of some ETFs, noted that the SPDR S&P 500 ETF from State Street Global Advisors turns over 10,000% per year. Many ETFs have turnover in the 2000% range (Bogle thinks even 30% is too high). Buy and hold, and do not trade, is Bogle’s advice. And less impressive authorities than Bogle agree: Intra-day trading can completely destroy the advantages ETFs offer for most investors.

And it’s not only transaction fees that can impact returns. Moving in and out of ETF positions can increase portfolio risk without providing any offsetting benefit to return expectations. Even with big, index-tracking ETFs, macroeconomic risks and liquidity risks still apply. But these can be multiplied when investors chase performance.

Investing in niche ETFs—and there are new ones every week—can increase political risk, liquidity risk, and risks from particular business sectors. It can also increase tax risks. Plus, most small funds take a while to establish themselves. Many close every year, and when they do, they can pay out capital gains distributions that can offset any tax benefits for the unwary. Some ETFs don’t offer big tax advantages, to begin with. Investors need to know the tax implications of increasing allocations to a given fund before they make moves, and the tax consequences of their buying and selling activity.

Educating Clients

Advisors with clients who may be prone to trade, rather than buy and hold, ETF shares should point out how fees quickly add up and erode returns.

Even more important than controlling costs is controlling emotions, says Rusty Vanneman, chief investment officer of CLS Investments. Advisors need to ensure that investors don’t chase performance but instead chase quality investment guidance. As with any investment, clients also need to understand the risks involved.

The Bottom Line

ETFs, particularly passive ETFs, are low-cost investment vehicles. That’s the key to their attractiveness to retail investors. Like mutual funds before them, they give mom-and-pop investors an inexpensive way to diversify. Yet ETF investors may be tempted to chase alpha even more so than mutual fund investors do, and advisors are well-positioned to provide clear guidance for clients who want to pursue this kind of strategy.