InvestorQ : What are the drawbacks of the ETF structure?
Katherine Gonsalves made post

What are the drawbacks of the ETF structure?

Arti Chavan answered.
3 years ago

ETFs offer a number of benefits like low-costs, varied investment options, flexibility etc. In addition, not all ETFs are alike. Management fees, execution prices, and tracking discrepancies can cause unpleasant surprises for investors. Let us look at some of the challenges that an investor may face while dealing with ETFs.

Trading costs

There is a trading cost to ETF. In the Indian context, this includes the cost of brokerage, statutory costs like STT/GST/Stamp duty, exchange fees, spread costs etc. Depending on where and how you trade, the cost to trade an ETF can be as much or at times even more than the management fees and tax efficiency. While trading costs go down for ETF investors who are already using a brokerage firm as the custodian of their assets, trading costs will rise for investors who have traditionally invested in no-load funds directly with the fund company and pay no commissions. In the Indian context, we call them Direct Plans and these are extremely economical considering that they don’t entail any marketing costs. Investors with a fund company cannot buy ETFs directly. They will have to open a brokerage account and pay a commission to buy shares. Low expenses of ETFs are routinely touted as one of their key benefits. But it has been found that most people invest regular sums of money in the form of SIP and that actually may entail more on commissions than you would save on ETF management fees and taxes.

Trading flexibility can be a myth at times

Trading flexibility is a second double-edged sword more often than not. The ability to trade anytime and as much as you want are a benefit to busy investors and active traders, but that flexibility can entice some people to trade too much. High turnover of a portfolio increases its cost and reduces returns. This downside risk of equities exists in ETFs too. ETFs have two prices, bid and ask. Investors should be aware of the spread between the price they will pay for shares (ask) and the price a share could be sold for (bid). In addition, it helps to know the intraday value of the fund when you are ready to execute a trade. At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. That is a market risk that you run on a regular basis.

Lifting the veil on the expense ratio

Not all ETFs are low cost as they are normally made out to be. Buyers of ETFs should look carefully at the expense ratio of the specific ETF. They could find that the ETF of their choice is expensive relative to a traditional market index fund. Then there is the risk of what is popularly referred to be the Market Creep (a cost most investors may not be aware of). For example, part of the fee creep can be attributed to an increase in marketing expenses. As ETFs proliferate, competition for funding is forcing companies to spend more money on marketing and that cost is passed on to current shareholders in the form of higher fees. Most buyers of ETFs do not realize but there is also the cost to license indexes. For example, if an ETF wants to run an index ETF on the Nifty, then license charges are payable to the NSE which can be quite steep. Index licensing is a big business in the investment industry. Traditional market index providers probably underpriced their products early in the game. But with global exposure and global best practices, index owners are now becoming savvier in pricing the index licenses.

Tracking error

Tracking error is a common challenge in most ETFs and index where the basic intent is to track an underlying index. ETF managers are supposed to keep investment performance in line with the indexes they track. Outperforming the indices is not the job of an index fund manager because that normally comes at a higher risk. The index fund manager or the ETF manager is only allowed to take on the beta risk; not the alpha risk. There are many ways an ETF can stray from its intended index. That tracking error can be a cost to investors. For example cash holdings, index changes etc can lead to higher tracking error in most cases.

There are few fundamental reasons why this tracking error arises in ETFs. For example, Indexes do not hold cash but ETFs do, so a certain amount of tracking error in an ETF is expected. Since the cash portion is zero return, there is a cost that is debited to the ETF. Fund managers generally hold some cash in a fund to pay administrative expenses and management fees. In addition, the timing of dividends is difficult because stocks go ex-dividend one day and pay the dividend on some other day while the indexes’ providers assume the dividend is reinvested on the same day the company went ex-dividend. This is a special problem for ETFs. That is the reason the ETFs can never precisely track a targeted index.

In many ETFs, Smart Beta can be a risk. What do we understand by Smart Beta? It is an index fund or an ETF where the fund manager has the leeway to either increase or decrease concentration in a particular component of the index to enhance returns. These run the risk of becoming virtual active funds which is the not core intent of ETFs anyway. ETF managers who deviate from the securities in an index often see the performance of the fund deviate as well. Several indexes hold one or two dominant positions that the ETF manager cannot replicate because of regularly restrictions on non-diversified funds. In an effort to create a more diversified sector ETF and avoid the problem of concentrated securities, some companies have targeted indexes that use an equal weighting methodology. Equal weighting solves the problem of concentrated positions, but it creates other problems.

The bottom line is that ETFs have their own challenges but they have surely emerged as a significant stride in helping investors earn more with lesser risk. Above all, it is the convenience and flexibility of ETFs that really sets them apart.