ETFs aren’t perfect

The title of this essay probably offends people. It seems as if over the past 7 years ETFs have been hailed as the perfect investment instrument. We’ll they’re not. No investment is impervious to failure. Unfortunately, I get the feeling that many are investing much of their nest egg in ETFs believing one or all of the following:

  • “There are little or no fees compared to actively managed investments so you’ll make more money!”
  • “Every ETF is invested in a diverse array of stocks protecting the investor from a downturn.”
  • “ETFs will always maintain liquidity.”

To start, ETFs are the untested elephant in the room. They gained immense traction after the recession in 2008 and have gained even more significant market share from 2014-2017. They have not been tested. We do not know how they will hold up in a market downturn in terms of liquidity or even compared to the portfolio of companies they represent.

Because ETFs are passively managed, they have the ability to create a speculative bubble within seemingly strong large-cap stocks. In order to create enough purchase volume for an ETF, the vehicle has to invest in larger companies. For that reason, companies like Facebook, Apple, and Netflix are all included in major cross-sector ETFs labeled as “Blue Chip”, “Emerging Growth”, “Technology”, and so on. As a single investor holds positions in multiple ETFs with large investments in the same companies, a problem is created. The investor did not explicitly choose to allocate X amount of his investment to Netflix because it is a good company. The blind investments cause companies become overvalued. The overvaluation, in turn, leads to more blind investments through ETFs. It is a vicious cycle.

If so much more of the market is being passively managed compared to pre-2008, then who is ultimately guiding these passive investments? The answer is fewer and fewer active investors.

See this website. The US Stock market is currently outpacing GDP by 30% for the first time since 1999. ETFs aren’t perfect and they could be the root of an imperfect market.

  • Edit #1: Do I even need to get into levered ETFs? Do You think an ETF labeled “3X Gold” actually backs your investment by purchasing three times the amount of gold of your purchase price?
  • Edit #2: No, I am not saying the market is going to crash tomorrow and that ETFs are going to be the only culprit. I am not saying ETFs need to be done away with. Everything in moderation… 40% of the market’s total value probably shouldn’t be indexed via ETFs… that is worrisome. I am saying that ETFs aren’t perfect.