Mitigate ETF Disadvantages
The goal of this article is to educate the self-directed investor about the disadvantages of ETF Investing, and how these disadvantages or problems can be mitigated. In order to get the maximum benefit of investing in ETFs it is important to identify and understand two crucial shortfalls. Fortunately, these shortfalls can be mitigated if investors have a clear comprehension of the disadvantages and how the solution can help optimize their portfolio.
ETF Disadvantages
Many ETFs participate in over diversification. ETFs are generally not actively managed, but are programmed to follow a specific index. The index, and therefore the ETF, may not own the very best stocks. A portfolio manager must weigh the benefits of diversification versus the disadvantages of diversification. It may be more advantageous to buy a limited number of the best companies in that industry rather than own the entire index.
The second problem is ETFs don’t rebalance their portfolio. Remember, most ETFs are programed to follow an index. In an index, as the winners increase in price they become a larger percentage of a portfolio. At the same time some stocks fall in price and become a smaller percentage of a portfolio. By owning the index, or ETF following the index, you may own more of expensive over priced stocks and less of the bargain underpriced or value stocks.
How to Mitigate ETF Investing Disadvantages
Both of these disadvantages can be mitigated by investing in a combination of ETFs and individual stocks. There are circumstances that are appropriate for ETFs and circumstances that are appropriate for individual stocks.
In cases where the portfolio manager wants a small percentage allocated to a specific index, sector, industry, cap size, region, country, etc., an ETF is the perfect investment vehicle. There are so many ETF choices; and this gives a portfolio manager many opportunities to gain exposure to virtually any asset category in the world. These choices include equities, bonds, currencies, commodities, and even inverse ETFs, etc. Therefore, small positions and positions that benefit from a great deal of diversification are prime candidates for using an ETF as an investment vehicle.
In cases where the portfolio manager has a larger percentage allocated to an asset it might be beneficial to pick the very best stocks for that category. For instance, most portfolios should have a large allocation to dividend growth stocks. This might be a category that would be optimized by owning the best individual stocks instead of owning an index or ETF that would own both the good and the bad stocks in the index.
Portfolio optimization occurs when the portfolio as a whole holds the best investments possible with enough diversification to nearly eliminate unsystematic or specific risk. Further diversification beyond a point will reduce potential returns more than it reduces portfolio risk.
I believe a combination of individual stocks and ETFs provide the optimum benefits with the least disadvantages. Self-directed investors who understand both the benefits and disadvantages of ETFs can better optimize their portfolio because they know how to use both types of investments to lower risks and increase returns.
Related Reading:
These Are the Reasons You Should Invest In ETFs
Asset Allocation and How ETF Portfolios Help
Inverse ETFs Provide Portfolio Hedging Strategies
| AAAMP Blog by Ken Faulkenberry | |
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Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
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