Exchange-traded fund investors have a vast array of options to choose from. There are thousands of ETFs available, covering numerous asset classes. However, it’s important to be aware of some common mistakes that investors often make when choosing ETFs. These mistakes include selecting ETFs that are too expensive, too risky, or poorly constructed. In this article, we will delve into these mistakes and provide alternatives to help you make better investment decisions.
Too Expensive
Many ETFs charge high fees, especially alternative ETFs, which typically charge significantly more than broad-based index ETFs. While it’s acceptable for certain types of ETFs to have higher fees, investors can run into trouble when they pay fees that are significantly greater than those of comparable ETFs.
Let’s take a look at an example. First Trust Value Line Dividend ETF (FVD) and Schwab US Dividend Equity ETF (SCHD) both target U.S. stocks that pay high dividends. Despite having similar objectives and being well-diversified, FVD has an expense ratio of 0.65%, while SCHD charges just 0.06%. Given the similarities between the two funds, there is no reason to pay more for FVD when SCHD offers a comparable option at a significantly lower cost.
Why pay a higher fee if you don’t have to? investment
Too Risky
Every investor has a different risk tolerance, and it’s important to match an ETF to that tolerance level. It’s advisable to avoid needlessly risky funds. To gauge an ETF’s risk level, consider factors such as volatility, drawdowns, and concentration.
For example, Invesco QQQ Trust (QQQ) tracks the performance of the largest 100 nonfinancial companies listed on the Nasdaq exchange. While QQQ has had phenomenal historical performance, it has also been more volatile compared to Vanguard S&P 500 ETF (VOO) and experienced steeper drawdowns. QQQ also has a higher concentration of technology stocks compared to VOO and Schwab US Dividend Equity ETF (SCHD), which increases concentration risk. Returns for QQQ are reliant on a few large technology stocks, which exposes investors to greater risk.
Investors who are unable to handle sharp drawdowns or high volatility may want to consider alternative ETFs like VOO or SCHD, which offer better risk management. investment
Poorly Constructed
Assessing an ETF’s fee and risk level is relatively easy, but understanding its investment strategy requires a closer look. While many popular index ETFs track sensibly constructed and well-diversified indexes, there are cases where poorly designed indexes slip through. To avoid investing in ETFs that track such indexes, investors should ask themselves one question: “Is there an economic rationale behind the strategy?” If the answer is no, it’s best to move on to the next option.
There are plenty of index ETFs that track indexes with compelling features. For example, Vanguard Total Stock Market ETF (VTI) holds 3,700 stocks and market-cap-weights them, allowing investors to tap into the market’s collective wisdom. Style ETFs, like iShares Russell 1000 Growth and Value ETFs, aim to outperform by selecting undervalued or high-growth stocks. Dividend ETFs, such as SPDR S&P Dividend ETF (SDY), provide a stable portfolio and consistent high yield.
On the other hand, there are ETFs that track flawed indexes. One example is SPDR Dow Jones Industrial Average ETF (DIA), which tracks the Dow Jones Industrial Average. This index, created in the 1800s to estimate U.S. economic activity, lacks a sound economic rationale. Holding just 30 stocks and using price weighting, it presents concentration risk and assigns higher portfolio weight based solely on stock price, without considering other economic factors.
Investors should avoid ETFs that lack a sound economic rationale for long-term investment. Always check under the hood before making your investment decisions. investment
Conclusion
By avoiding these three common mistakes in ETF investing, you can improve your investment outcomes. Remember to consider the fees, risk level, and investment strategy of each ETF before making your investment decisions. By making informed choices and selecting ETFs that align with your goals and risk tolerance, you can optimize your investment portfolio.
Invest wisely and achieve your investment goals with confidence! investment
