For many decades, investors have had the opportunity to invest in ETFs (Exchange Traded Funds). An ETF is a security that tracks an index, but has the ability to trade like a stock on any given exchange. When one purchases this investment tool, they get the diversification of an index fund. Moreover, an ETF can be shorted, bought on the margin, and tends to be cheaper than the maintenance costs of a mutual fund. Many investors feel that owning ETFs mitigate their overall risks because they avoid the risk of owning a stock and dealing with the potential problems that an individual company may face.
So, are these investments really as safe as they claim to be? ETFs are actually immensely complicated equities. Let me explain this in more detail to you. When one purchases this type of investment they are not purchasing a share of a company, a bond, or a physical asset. An investor purchases a piece of paper which “follows the trend” of any given sector or market. Let's say an investor pours $10,000 into an oil and gas ETF. If the price of WTI (West Texas Intermediate) is trading at $80 a barrel, the ETF's price will reflect the price of WTI. But wait! What happens if the price of WTI dips to under $55 a barrel? The answer is simple, your investment will simply go into free fall.Credit: Wikimedia Commons
Essentially your ETF is a worthless piece of paper, which forces you to hope that the price of whichever commodity you are tied to stays at that given price (or ultimately goes higher). In many cases, once an ETF falls below the initial purchase price, it becomes nearly impossible to counter your losses. Over the past decade these investment tools have morphed into more complex investments. They are available in an array of forms including any commodity that you can think of such as gold, coal, copper, and orange juice. In addition, there are tons of them that purposely short certain sectors and bet on super volatile emerging markets.
Unlike companies, ETFs fail to have management teams, pay dividends, buyback shares, split shares, have spin-offs, or engage in any form of merger/acquisition. In the long run, purchasing stock in companies may seem risky as well, but an ETF will ultimately expose investors to colossal amounts of risk. Furthermore, if a person buys a stock at let's say $10 a share and the company pays a dividend, the investor can initiate a DRIP (Dividend Reinvestment Program). The DRIP program will purchase full or fractional shares at the lower share price (let's say the stock dipped to $7.80 a share). Even if the share price continued to plummet the dividend serves as a safety net which an ETF typically will not offer (although, in some specific cases an ETF may pay a dividend).Credit: Wikimedia Commons
A common scenario when investing in ETFs deals directly with investors diving directly into volatility indexes. This means that an investor will buy an ETF hoping that the stock market goes down or up. Again, this investor does not own part of a company or even a bond, the ETF just follows the market and/or sector's uncontrollable movement.
Another scenario when investing in ETFs has to do with an investor attempting to find the next big stock. Typically an investor will purchase stock in let's say a pharmaceutical company, then they will hope that the company finds the next cure for whichever disease it may be. The only problem is; what if that company only makes up a small part of the ETF (around less than 5% of the ETF's holdings). In addition, suppose one of the major pharmaceutical companies finds the cure instead? Can the investor manage the ETFs entire holdings? The answer is no. In the end, that ETF will only follow the pharmaceutical sector as a whole. Even if one of the companies which makes up the ETF were to surge in share value, that does not mean the others will follow. In actuality, the others may temporarily go down in value. The investor will find themselves with an ETF which did indeed have a basket of stocks that attained their goal of finding the next cure for a disease, but since it was an ETF (diluted with so many competitors in the sector) they never made a large gain on their investment.
So, ETFs may seem to be magnificent investments because they are so simple. In reality, simple investments are not necessarily good investments. A few other things when considering investing in them are potential annual costs, lack of knowing which companies make up the ETF, and the possibility of an ETF being shut down due to lack of investors.Credit: Wikimedia Commons
There is no doubt that investing can be complex and many money managers created ETFs to make investor's lives easier. In the end, these investments are just another complicated piece of paper posing as a valuable equity trying to convince you that you are invested in a blue-chip company with top-tier management and a proven track record. Most of the time ETFs are anything but that.
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