ETFs – A Flawed Investment?

ETFs have been around long enough that I can analyze my initial thoughts about them and decide if they were correct or need to be modified. I know a lot of people, including many financial planners, love ETFs but I did not when they first were introduced and I still do not. As someone who believes in passive investing, ETFs may seem like a good idea but I just don’t see it.

Let me start by saying that there are good aspects of ETFs that work in theory better than they work in practice. For example, an ETF is priced throughout the day and can be bought and sold at any time. Unlike a mutual fund that is only priced once, at the close, an ETF seems to have a huge advantage. If the market is dropping quickly you could sell the ETF at midday rather than at the close, possibly limiting your losses. So what’s the downside of that? This feature encourages trading rather than investing. One down day (week, month, or year), even a precipitous drop, doesn’t mean you should sell if you have a long term outlook. Human nature being what it is I feel ETFs make it more likely to sell low and buy high. Of course if you are disciplined and have a plan that you stick with you can negate this potential trap.

ETFs follow an index giving you more diversification than individual stocks. Again that is true but the so called indexes that some ETFs follow are nothing more than sector funds in index clothing. There are technology ETFs and gold ETFs and health care ETFs to name a few and their only diversification is a broad swath of the same sector. To be fair there are some ETFs that follow the traditional indexes such as the S&P 500 but with the proliferation of the ETFs I think many people end up in the wrong ETF.

Then there is the cost of the transaction. Like any investment you can dollar cost average into ETFs but each purchase will carry a commission. Even using a discount broker that would be $9.99 (for example) per trade. If you bought one EFT a month for a year that’s about $120 and two ETFs a month would be $240. So what’s the alternative? I have an account with Vanguard and if you purchase their mutual funds there is no commission. I just saved $240 or more and was more diversified than an ETF that follows a pseudo index.

So does this mean I don’t own any ETFs? Well no it doesn’t, because there are some things for which I could not find a suitable mutual fund. The one ETF I own is an inverse US Treasury Bond ETF. Interest rates are incredibly, artificially low in my opinion. That doesn’t mean they will go up any time soon but when they do I will have an ETF that will do very well. Remember I have a long term outlook.

There are uses for ETFs and they could be a valuable addition to your portfolio but I don’t think they work for me. What do you think?

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