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However, with ETFs as with anything else, there are a few possible pitfalls to keep in mind. When you’re using ETFs to build your global portfolio, you might want to be aware of the following mistakes – remember, awareness can help you avoid them.
1. Understand what you own
ETFs vary widely in their construction and operation, and sometimes, something that looks like an ETF turns out not to be one. An ETF is a fund that directly owns the assets it tracks. In other words, if you buy shares in an S&P 500 ETF, you will own a small piece of all the shares in the S&P 500. However, ETFs can have different tax structures, and even funds that sound similar can actually have quite different constituents. Be certain that you fully understand exactly how the ETF you purchase is constructed.
Also, be aware that there are ETF-like funds out there called ETNs (exchange-traded notes) that sometimes look like ETFs, but really aren’t. While ETFs directly invest in the assets that they’re tracking (an S&P 500 ETF will buy S&P 500 shares), ETNs are actually debt instruments linked to the performance of the assets being tracked (see a full discussion of the difference here). ETNs can be a good option, but they are more complex than ETFs. Make sure you know what you’re buying.
2. Watch those fees
The major advantage of ETFs is that they typically charge very low fees. However, these days, there are “actively managed” ETFs (bit of an oxymoron, I think!) that charge much higher fees than you might expect. What’s more, even when you’re looking at a basic ETF, like a bog-standard S&P 500 tracker, there can be quite substantial variation in the fees charged by different funds. Once again, you need to be savvy. If you want to invest in a particular set of assets or index, shop around and see what different ETFs are available, and compare their costs. Even a few fractions of a percent can make a difference to your long-term returns.
3. Be wary when loading up on sector-specific ETFs
When you head into the world of global ETF investing, it’s easy to get overwhelmed with the choice available. While there are boring old S&P 500 index trackers, there are also highly specialised options, like ETFs that invest only in oil and gas exploration companies, or social media firms, or biotech startups. The temptation to invest in specific, sexy sectors can be overwhelming.
However, there are risks to doing this. First of all, when picking sectors, people often rely on past performance data to make their choice. Given the fact that individual sectors can be much more volatile than the market as a whole, this can be a risky approach.
The bigger problem, however, is that piling money into particular sectors can leave you with a very undiversified portfolio. One of the lynchpins of a good investment strategy is that you should focus on developing a balanced, diversified portfolio. This can be done with ETFs, but if you focus too much on sector-specific funds, you can easily end up with a portfolio in which you have concentrated all your risk in a handful of sectors.
So think broadly about your ETF choices, and only invest in funds that help you build a portfolio that is, overall, balanced and diversified.
4. Your ETF is not your spouse
This particular mistake is not unique to ETFs, it happens with individual stocks too. Basically, you should not be overly committed to any ETF that you are invested in. Buying an ETF is not a marriage contract – if the ETF starts to dramatically underperform, or if it is no longer an appropriate part of your overall investment portfolio, you should be prepared to sell. Just as you shouldn’t ever fall in love with an individual stock, and stick with it through thick and thin, so you shouldn’t become too committed to a particular ETF. Again, you need to maintain balance and diversity in your portfolio, and make sure that all the assets you own are contributing in some way to your overall portfolio.
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