3 Important Shortcomings You Should Know About Passive Investing

“Passive” investing removes human hunches from the process of what to buy and sell. Essentially, in a passive fund such as a passive Exchange Traded Fund (ETF), the portfolio manager follows a blueprint, such as an existing index, and does not actively manage the portfolio. However, if passive investing sounds like a simple, cost effective and easy way to protect and build wealth, why doesn’t everyone invest this way? The following article highlights 3 important ETF shortcomings all investors should be aware of.

What Is An ETF?

An ETF, or Exchange Traded Fund, is a basket of securities that closely tracks an index, sector, commodity or other existing pool of assets. In general, ETFs are considered a form of passive investing given the lack of active input by a Portfolio Manager in selecting the investments that are held in the fund. The price of an ETF fluctuates throughout the trading day because it can be bought or sold in the stock market just like any other stock.

3 Important Shortcomings Of Investing In ETFs All Investors Should Know

While ETFs have enjoyed a spectacular growth in popularity, like all good things, they also have drawbacks. Here are 3 important shortcomings to these investments that investors should understand.

1. Giving Up Control

Since ETFs are comprised of several stock holdings, they appeal to many investors because investors can receive a basket of securities with a single ETF purchase. The same appeal can be viewed as a limitation since investors do not have a say on the individual stocks in an ETF. For investors wanting to avoid a particular company or industry, for a reason such as personal values, they do not have the same level of control as investors who select individual stocks for their own portfolio—or entrust a discretionary portfolio manager to do so with instructions as to what to avoid.

2. Underlying Value vs. Price

ETFs have two forms of value: the net asset value, which is the value of its investments, and the trading value, which is the price the ETF trades at on the stock market. At times the price at which ETFs trade can be higher or lower than the underlying value of the investments, which can lead to situations in which investors might be paying a premium over the cost of the underlying assets in an ETF.

3. Return Expectations

Though not really a drawback, investors should invest in ETFs with an understanding of what to expect from the ETF’s performance. ETFs are generally linked to a benchmark index, which means that they are designed to match the index and perform in line with the index. Investors looking for investments that are more active in nature which have the potential to outperform the underlying index may wish to build their own portfolio or may choose to hire a portfolio manager to build a personalized portfolio for them.

Conclusion

Now that you understand the 3 important shortcomings that come with passive investing and in particular, passive ETFs, you can make better investment decisions. Investing requires you to be familiar with the facts about a particular investment vehicle and the same applies to understanding ETFs prior to purchase.

This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.