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Despite the following impressive statistics, equity exchange traded funds have disadvantages.
- Assets Under Management (AUM): In October 2024, AUM were in excess of ~$13T and had experienced a ~20% cumulative annualized growth rate (CAGR) since 2008.
- Number of ETFs: Over 12,000 ETFs listed globally.
- Market share: ETFs have more than doubled their market share relative to mutual funds in the past decade, from ~14% to ~32%.
Although ETFs serve a purpose, I draw your attention to some reasons why investing through equity ETFs is not all it is cracked up to be.
Common Arguments Against ETFs
Not all ETFs are created equally. Fee structures, liquidity, and complexity are some of the common arguments against ETFs. Clearly, a direct comparison between a money market ETF and an ETF on steroids (those which employ a significant degree of leverage that can maximize returns and losses) is not possible. We can not, therefore, simply state that all ETFs are great or terrible.
Some ETF Holdings Are Toxic
No investor should rely solely on the output generated by stock screeners to make investment decisions. I do not, however, have the time to look at the financial statements for thousands of companies. For my immediate purposes, therefore, I rely on output from the Finviz stock screener and am restricting my search to US companies.
The following reflects the number of companies using the following search parameters.
NASDAQ 100
- 11 - negative Net Profit Margin
- 11 - negative Operating Margin
- 11 - negative Return On Investment
- 26 - Debt/Equity greater than 1.0x
- 22 - Long-Term Debt/Equity greater than 1.00x
- 21 - Current ratio less than 1.00x
S&P 500
- 26 - negative Net Profit Margin
- 15 - negative Operating Margin
- 26 - negative Return On Investment
- 181 - Debt/Equity greater than 1.0x
- 159 - Long-Term Debt greater than 1.00x
- 133 - Current ratio less than 1.00x
Russell 2000
- 716 - negative Net Profit Margin
- 519 - negative Operating Margin
- 810 - negative Return On Investment
- 538 - Debt/Equity greater than 1.00x
- 458 - Long-Term Debt/Equity greater than 1.00x
- 410 - Current ratio less than 1.00x
Fees
The sheer number and variety of ETFs means fee structures are 'all over the map'.
ETFs have operating expense ratios for managing the fund and trading costs like commissions and bid/ask spreads that affect returns.
Most broad market index ETFs have a 0.10% - 0.20% Management Expense Ratio (MER) range while most active ETF strategies have a 0.75% - 0.90% MER range. There are, however, some ETFs with a 1.00% - 2.00% annual MER. Some ETFs have even higher fees.
These fees are insignificant on a $100,000 ETF; a 0.20% MER on a $100,000 investment is $200/year while a 1% MER is $1000/year. Imagine having a $5,000,000 Russell 2000 ETF with a 0.50% MER; a 0.50% MER becomes $25,000/year while a 1% MER becomes $50,000/year....for exposure to many companies to which you should have NO exposure!
ETF investors also encounter other costs. The Charles Schwab website provides a good overview.
Valuation Risk
ETFs are typically structured to be passive investments and are not intended to outperform their benchmark. These ETFs, therefore, endeavor to replicate the weighting of the companies within a particular 'space'.
A NASDAQ 100 ETF's largest exposure is to Apple, Microsoft, NVidia, Amazon, Google, Meta, and Tesla. If these companies are grossly overvalued and you invest new money in a NASDAQ 100 ETF, you are investing in overvalued companies. The time to invest in great companies, however, is when valuations are attractive. Given current market conditions, is this really the time to aggressively invest in a NASDAQ 100 ETF?
Equity Exchange Traded Funds Disadvantages - Final Thoughts
There are definitely instances where investing in equities through ETFs may be appropriate. If you desire direct exposure to international companies, for example, investing through an international ETF may be appropriate.
I, for example, know virtually nothing about most companies outside North America. I can't even understand their financial statements in order to make intelligent investment decisions. Why, however, should I invest in international companies when I can gain international exposure by investing in US companies with international operations?
What prompted me to write a post on this topic was a Peloton (PTON) advertisement I saw on a social media platform. I have never invested in this company and have never looked at its financial statements...until now.
WOW! If I were a PTON employee, I would be expending a considerable level of effort to find alternate employment.
As I delved into PTON's numbers, I got to wondering just how many other toxic companies are included in various indices.
Many of the companies I quickly analyzed for the purpose of writing this post exposed me to just how many US companies are one 'accident' away from becoming insolvent; a company's market cap or share price provide no indication of how toxic a company may be.
Earlier in this post, I reflect the number of companies within different indices with less than stellar metrics; my search parameters are set arbitrarily. Apply more conservative cut-off metrics and the number of 'uninvestable' companies increases dramatically. For example:
- 188 companies within the S&P 500 have a Net Profit Margin under 10% versus 26 with a negative Net Profit Margin.
- 309 companies within the S&P 500 have a Long-Term Debt ratio greater than 0.5x versus 159 with a Long-Term Debt ratio greater than 1.00x.
Some ETF investors may argue the weighting of these toxic companies is immaterial. At some point, however, the sum of the immaterial weightings of a large number of companies within an ETF becomes material. Making matters worse, investors are paying fees to invest in companies to which they should have no exposure.
Giving more thought to the number of public companies teetering on the brink of insolvency, I got to thinking about all the people who have sunk their hard earned money into equities because they were told they need to 'invest for their future'. Many of these investors may acknowledge their area of expertise is not in the analysis of publicly traded companies, and therefore, they have invested in equity ETFs. The world of ETFs, however, is becoming increasingly complex. Selecting ETF investments can be equally difficult as selecting appropriate companies in which to directly acquire shares.
Throughout my rudimentary analysis of ETFs for the purposes of composing this post, I could not stop think about Warren Buffett's two key rules of investing:
- Rule #1: "Never lose money"; and
- Rule #2 "Never forget Rule No. 1".
Sadly, I suspect many ETF investors who invest certain ETFs that are totally unsuitable for their risk profile will be sorely disappointed.
I wish you much success on your journey to financial freedom!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.
