Exchange-traded funds are an excellent choice for many types of investing. However, they’re not a catch-all where they’re perfect for everyone or every situation. Also, when deciding ETFs are right for you, there are certain things that you should not do with them. Not avoiding these pitfalls can become expensive or at the very least, inconvenient.
To examine what not to do when investing in ETFs, here’s our complete rundown.
Don’t Invest When You Don’t Understand Them
It may seem strange to some people, but often investors buy into ideas floated by an investment magazine or a well-meaning friend who says, “You should invest in ETFs”.
It’s natural to get excited and look at how to acquire them before even knowing what they are. Don’t do this. Instead, learn about ETFs first, then see if they’re right for you. Why do it this way? Because you cannot know if they’re appropriate before understanding them fully. This way, you won’t put the cart before the horse.
Ask the question: what are exchange traded funds? The linked article from Wealthsimple – a leading low-cost investment management firm – provides a thorough overview based on their deep understanding of markets and investment products. If you like the sound of ETFs, Wealthsimple can help you get started.
The simpler answer, for now, is that they’re securities that get traded on the stock market – like the TSX exchange – and they contain other securities inside them too. Therefore, with a single trade, it’s possible to take a position in a whole index, a sector, or using an investing style (value, growth, momentum) without needing to make additional purchases.
Think Twice If the Investment & Related Fees Are Higher
The investment fees in Canada have always been high. In recent years, they’ve been above the typical average mutual fund cost in the U.S. too. This can grate if you’re a Canadian investor.
The advent of many ETFs being released in Canada has made it possible to reduce investment costs but don’t make the mistake of believing that it’s all sunshine and rainbows.
Compare Fees of ETFs Vs. Other Alternatives
Depending on the index fund, mutual funds can be less expensive than ETFs following an identical index or investing style. Indeed, their results may be similar except for the drag on performance that investment fees place on the capital invested. Therefore, do weigh all your options to see whether ETFs offer something more or are just more expensive.
Consider All Trading Costs
While a mutual fund may come with a front-end load (a commission) and perhaps other commissions too, that’s not always the case. Index mutual funds are far less expensive than actively managed funds, all other things being equal. When purchasing an index ETF, the expense ratio may surprise you by how low it is.
Do bear in mind though that there are often trading costs associated with ETFs. As such, they commonly carry additional expenses to buy and sell them because they’re a tradeable security. Factor this into the overall expense ratio because it may materially change which is the cheaper option.
Don’t Forget About ‘Buy and Hold’ Investing
The idea with ‘Buy and Hold’ investing is that by acquiring an investment, it should stay held for as long as possible. While this isn’t always the right approach when purchasing common stocks – Warren Buffett previously stated that he wished he’d sold Coca-Cola when it was vastly overvalued – for ETFs, holding long-term is economical.
Stock Market Trends
The trend with markets is that they move significantly in short bursts. Investors can find that their portfolio hasn’t substantially increased in value for several years but suddenly sees double-digit gains over the next few years.
Usually, these types of expansive movements aren’t predictable. Indeed, the gains in a single year can occur over a 1–2-month period with the rest of the year essentially flat. So, being out of the market can see you missing out.
Keeping Trading Costs Lower
With ETFs where there are often trading fees to acquire and later sell the security, investors must hold for the long-term. Trading in and out increases the costs substantially compared to sitting on the investment. Just because an ETF can be traded very quickly compared to a mutual fund doesn’t mean that it should.
Historically, investors who traded more frequently saw lower total returns compared to sloth-like investors who traded infrequently. That’s worth remembering.
Avoid Paying Transfer Fees
If you’re thinking of moving to a different broker or perhaps a Robo-advisor, then do consider any transfer fees to move funds or ETFs. The fees may be charged per holding or per account. They can add up fast if you’re widely diversified.
The institution that’s receiving your investment account business may be willing to cover some or all of those transfer costs. It may depend on the balance in your account too, as some investment institutions will only do it with account balances above a certain amount. However, given that transfer fees can sometimes be $150, it’s worth looking into.
Chasing the Latest Trend
The latest trends in ETF investing are popular with any websites or investment magazines that publish articles. They’re in the business of drumming up interest. Some of their headlines even border of being click-bait rather than being informative or incredibly useful.
When consuming too much news relating to ETFs, it’s possible to get caught up in the latest trends. This can lead you down a path of investing heavily into leveraged ETFs or inverse ones that deliver an outsized return (positive or negative) relative to the market or index they track. Unless you know exactly what you’re doing, it’s the easiest way to lose your shirt!
Also, if a friend knows that you use ETFs and don’t buy individual stocks, they may start to share their latest ETF scoops or random investment ideas with you. It’s best to ask them to stop that by explaining that you have an investment plan, and you don’t wish to be distracted by other ideas.
Going Too Heavy into Sector Investing
On a similar note, sector investing is popular and useful. If you wish to double-down on a particular sector – such as technology or green energy – there’s an ETF just waiting for you.
What you should bear in mind though is that industry performance is inherently unpredictable unlike the long-term performance of the TSX or S&P 500 indices that both have a long track record.
Industries go into unexpected, prolonged, and sometimes never-ending decline. Think about buggy whips in the 1900s when Ford was starting out and the automobile began to replace the horse and cart. Anyone investing in related equipment, including the buggy whip, was in for a rude awakening. And that can happen to any industry, especially when investing in especially narrow ones.
Swapping Between Different Investment Styles
Similar to sectors, hopping between investment styles is a bad idea.
The main two styles are value and growth investing but playing the leveraged game with levered or inverse ETFs is a popular style. Another shorter-term one is momentum investing where people try to gain through the movement of certain stocks and expect the ETF to no longer own it right before the music stops.
Decide on an investment strategy. Create a plan. Then stick to it. Swapping between value, growth, and other investment styles are rarely successful because investors are lousy at market timing.
The Age and Provider of the ETF
Many ETFs are created and launched each year. Be careful when selecting one. Don’t choose one that was newly issued. If it was, it will have no recent track record of performance.
While the ETF may intend to track an index, there’s nothing to say whether the managers are capable of doing that accurately or will experience substantial tracking error. Also, if the ETF provider is not well known or is also new, that should be a cause for concern too.
The flip side to this coin is when the ETF is a newborn but it’s from a well-known provider like Vanguard. In which case, investors would have fewer concerns.
Not Understanding If an ETF is Actively Managed or Indexed
Some investors assume that an ETF is passive and tracks an index. That’s not always the case.
Plenty of actively managed ETFs are being launched both in the U.S. and Canada. Investment houses know that people looking to deploy capital into new investments are keenly looking at ETFs. They see an opportunity with the trend swinging over to ETFs and away from mutual funds.
It’s imperative to know whether an ETF is actively managed with one or more managers operating it or if it’s set up to track an index. The problem with active management is that it’s unpredictable, the managers can change, and the performance streaks end suddenly. Investors may hear about a “hot fund” or a “hot ETF” but by that time, the outsized returns are finished. Wherever possible, stick with index ETFs to avoid unwanted surprises.
ETF investing is easy. However, there are still many ways to mess up and get a worse outcome than you deserve. By avoiding some of the obstacles and pitfalls above, it’s possible to reap increased rewards by using a steady hand with your investing portfolio.