In a world where the investment landscape is always changing, finding a reliable, low-risk option is key. With the rise of exchange traded funds (ETFs), many investors have found a cost-effective, transparent, flexible, and passive approach to investing.
So what is an ETF? ETFs are a type of investment that holds a basket of securities, including stocks, bonds, and commodities. ETF shares are traded on stock exchanges, so you can buy or sell shares throughout the trading day at market-determined prices.
But as an investor, it is important to know that passive investing does not mean a risk-free investment strategy. Like any investment, ETFs also come with their own risks and flaws, such as over diversification, tracking error, and commission fees, which can impact your returns. Let’s understand these ETF flaws in more detail so that the investments you make are well informed.
- Concentration risk
ETFs are known for their diversification benefits, but sometimes these benefits are limited due to the structure of the ETF or the index it tracks. Some ETFs may only track specific sectors. It can result in over-concentration in those areas, making them vulnerable to major price swings or regulatory changes.
For example, suppose an ETF tracks the technology sector and holds a large percentage of its assets in just a few technology stocks. In that case, the ETF may experience major losses if any of the individual stocks have a negative news event or face regulatory concerns.
So, carefully review an ETF’s holdings to ensure you are comfortable with the level of concentration risk before investing in it.
- Tracking errors
The tracking error is the difference between the return of the ETF and the index it is tracking. While ETF funds aim to minimise these tracking errors, this can still happen due to factors such as market volatility, trading costs, problems in buying and selling securities, or fund managers taking above average risk.
The impact of tracking errors can be significant, as even a small percentage difference in returns can add up over time. For example, if the ETF you purchased experiences 4% tracking error and its returns are 4% lower than the underlying index, it means you missed out on 4% of potential gains.
- Transaction costs
ETFs may appear to have low expense ratios compared to most other types of mutual funds. However, ETFs are traded on exchanges like stocks, meaning you may incur transaction costs each time you buy or sell. These fees can add up quickly, especially if you trade frequently or have a small investment portfolio, and it may significantly reduce your net ETF returns.
- Lack of control over its composition
ETFs are designed to follow an index or group of indices, limiting an investor’s ability to exclude individual companies that do not meet their investment standards or values.
For example, the Nifty 50 is a benchmark index that tracks the performance of 50 largest companies listed on the NSE (National Stock Exchange). While investing in a Nifty 50 ETF can provide investors with exposure across different sectors and companies, it may include certain companies that do not meet your investment standards or values.
To wrap up
While ETF investments offer significant advantages such as diversification, lower costs, and ease of trade, there are potential risks that should not be overlooked. Whether it’s liquidity issues or the commission fees, every risk matters in the overall success of your investment strategy. So, before investing in any ETF, research it well and compare it with other funds.
Also, conducting a thorough analysis of your investment goals, risk tolerance, and short- and long-term needs can further help you maximise the benefits of ETFs.
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