ETFs have many advantages over other financial products. They cost less in fees, they are easier to trade, and they can offer diversified exposure to a variety of asset classes.
However, certain habits and tendencies cause many investors to earn less in returns than the funds themselves, reported the Wall Street Journal.
First, they to get caught up in hype surrounding different smart-beta products. According to Phil Bak, CEO at US-based ACSI Funds and former head of ETF listings at the New York Stock Exchange, strategies that become popular get too expensive, which drags on performance.
Dividend-focused ETFs performed well during part of 2015 and last year, but have not done as well recently because institutional players have rotated their exposures, switching to strategies they think are due to rebound. Such variations in performance should be expected, so investors should think about whether their time horizons are long enough to ride out the dips.
Second, they don’t consider the timing. An ETF’s net asset value should closely track the value of its holdings. But it can diverge especially early in the day, before some stocks have opened, or near the close when volatility can go up from a rush of late orders. According to Joel Dickson, Vanguard Group’s global head of investment research and development, investors can minimize transaction costs by avoiding these times.
Third, they tend to be too focused on low expense ratios. Todd Rosenbluth, head of ETF and mutual-fund research at CFRA, told the Journal that the holdings in the underlying index may impact performance more significantly than fees do.
As an example, he compared a Vanguard ETF and an iShares fund, which have expense ratios of 0.07% and 0.08%, respectively. While they’re similar, the iShares fund has more French and German stocks and no Canadian exposure, allowing it to gain nearly 15% this year — considerably better than the Vanguard ETF’s 14% gain.
Fourth, investors tend to get into narrow sectors that may lag behind or be more volatile than the broader market index. As an example, advisor Jay Batcha noted how investors poured into a US financial-sector ETF, thinking that it would benefit from deregulation and rising interest rates. At one point in June, it was up only marginally for the year while the S&P was up 8%, but it surged later on to catch up. The narrower an ETF’s strategy, the more volatile it is.
Fifth, investors may buy ETF with factor strategies that are too focused. According to Batcha, having more factors will tend to smooth performance over a market cycle. Reading ETF fact sheets to find strategies that are spread out can be beneficial. However, he added, it’s best to avoid ETFs whose strategies aren’t well explained in literature.
“If, after a half-hour, you are still scratching your head and trying to figure out when an ETF might or might not do well, perhaps that investment is too complicated for you,” he said.
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