Exchange Traded Funds (ETFs) are passively managed investments designed to mirror specific indices or commodities like gold and silver. SEBI regulations require ETFs to invest at least 95% of their assets in the securities that make up their target index. Fund managers are tasked with replicating the index's performance, adjusting the ETF's holdings to reflect any changes in the index's composition or weighting. While ETFs offer convenient market exposure, they also carry potential drawbacks. This discussion explores the disadvantages of ETFs, including potential issues like higher costs, market volatility, limited diversification, the lack of active rebalancing, sector-specific risks, liquidity concerns, and the complexities of niche or leveraged ETFs.
Overview of ETFs
An ETF, or exchange-traded fund, works like a group fund you can buy and sell on the market, much like how you trade stocks. This is different from mutual funds in the way that mutual funds also pool money but are only traded once a day after the market closes.
ETFs can replicate a wide array of assets and can be made to follow specific investing plans, offering a varied way to manage assets.
Disadvantages of ETFs
ETFs are popular investment vehicles, but they also have some disadvantages that investors should be aware of.
Less diversification
ETFs are designed to track a specific index or sector, which means they may not provide the same level of diversification as a traditional mutual fund or a diversified portfolio. This can lead to higher risk and volatility for investors.
Intraday pricing might cause unwise trading
ETFs are traded on stock exchanges like other securities, which means their prices can fluctuate rapidly during the trading day. This can lead to unwise trading decisions if investors are not careful, as they may buy or sell at the wrong price.
Costs could be higher
ETFs often have higher costs compared to traditional mutual funds, including management fees, administrative fees, and other expenses. These costs can eat into the returns of the ETF, making it less attractive to investors.
Lower dividend yields
ETFs are designed to track a specific index or sector, which means they may not provide the same level of dividend yields as a traditional dividend-paying stock. This can be a disadvantage for investors who rely on dividend income.
Skewed leveraged ETF returns
Leveraged ETFs are designed to amplify the returns of the underlying index or sector. However, these ETFs can also experience skewed returns, which means they may not always provide the expected returns. This can be a disadvantage for investors who are not prepared for such volatility.
Taxation of Gains from ETF Units
When you invest in Exchange Traded Funds (ETFs), the profits you earn are subject to capital gains tax under Indian income tax laws. The tax rate and categorization of gains (short-term or long-term) depend on the type of ETF and how long you hold the units.
Equity-oriented ETFs, which track equity indices, are taxed similarly to equity mutual funds.
ETFs that track debt indices or commodities are taxed like non-equity mutual funds.
The following table provides a summary of the applicable tax rates:
Type of ETF |
Holding Period |
Capital Gain |
Tax Rate |
Equity-oriented ETF |
Less than 12 months |
Short-Term Capital Gain (STCG) |
15% |
Equity-oriented ETF |
12 months or more |
Long-Term Capital Gain (LTCG) |
10% (after ₹1 lakh exemption for LTCG from equity shares and equity funds in aggregate in a financial year) |
ETF other than equity-oriented |
Less than 36 months |
STCG |
According to your income tax slab |
ETF other than equity-oriented |
36 months or more |
LTCG |
20% with indexation |
10 ETF concerns that investors shouldn’t overlook in 2025
Exchange Traded Funds (ETFs) have become increasingly popular investment vehicles, offering diversification and accessibility. However, like any investment, ETFs come with potential drawbacks that investors should carefully consider. Understanding these risks is crucial for making informed decisions and managing your portfolio effectively. This analysis outlines ten key concerns related to ETFs that investors should be aware of in 2025.
1. Commissions and expenses
While ETFs are often touted for their low expense ratios, costs can still add up. Beyond the expense ratio, consider trading commissions when buying and selling ETF shares. Frequent trading can significantly erode returns due to these transaction costs. Also, some ETFs might have underlying holdings with their own embedded expenses, further increasing the overall cost. It's essential to factor in all potential costs, including brokerage fees, expense ratios, and any other administrative charges, to accurately assess the net return on your investment.
2. Underlying fluctuations and risks
ETFs track specific indices or benchmarks, meaning their performance is directly tied to the fluctuations of those underlying assets. If the index declines, the ETF will likely decline as well. This inherent market risk is unavoidable. Furthermore, certain ETFs may concentrate on specific sectors or industries, amplifying risk if that sector experiences a downturn. Understanding the composition of the underlying index and its historical volatility is crucial before investing.
3. Low liquidity
While many popular ETFs boast high trading volumes and liquidity, not all ETFs are created equal. Some niche or thinly traded ETFs may have limited liquidity, making it difficult to buy or sell shares, especially in large quantities, without significantly impacting the price. Low liquidity can lead to wider bid-ask spreads, increasing transaction costs and potentially hindering your ability to exit a position quickly.
4. Capital gains distributions
ETFs, like mutual funds, can distribute capital gains to shareholders. These distributions are taxable, even if you reinvest them. Unexpected capital gain distributions can create unanticipated tax liabilities, impacting your overall return. It's important to be aware of an ETF's distribution policy and factor potential capital gains taxes into your investment strategy.
5. Lump sum vs. Dollar-cost averaging
The method of investing can impact returns. While lump-sum investing has historically outperformed dollar-cost averaging (DCA) in some cases, DCA can be a more prudent approach for risk-averse investors. DCA involves investing a fixed amount of money at regular intervals, regardless of the market fluctuations. This strategy can help mitigate the risk of investing a large sum at a market peak. The choice between lump-sum and DCA depends on individual risk tolerance and market conditions.
6. Leveraged ETFs
Leveraged ETFs aim to amplify returns by using derivatives and leverage. While they can magnify gains, they also magnify losses. These ETFs are designed for short-term trading and are not suitable for long-term investors. The complexity and volatility of leveraged ETFs make them risky for inexperienced investors.
7. ETFs vs. ETNs
It's crucial to distinguish between ETFs and Exchange Traded Notes (ETNs). While both are traded on exchanges, they are fundamentally different. ETFs represent ownership in a basket of assets, while ETNs are debt instruments that promise to pay a return linked to a specific index or benchmark. ETNs carry credit risk, as their performance is dependent on the issuer's ability to pay.
8. Reduced taxable income flexibility
ETFs generally offer less flexibility than individual stocks when it comes to managing taxable income. With individual stocks, investors can strategically time their sales to manage capital gains taxes. ETFs, due to their index-tracking nature, offer less control over the timing of distributions and the realization of capital gains.
9. ETF premium (or discount) to underlying value
Ideally, an ETF's price should closely track the net asset value (NAV) of its underlying holdings. However, at times, an ETF's market price can deviate from its NAV, trading at a premium or discount. Significant premiums or discounts can impact returns and create arbitrage opportunities. Investors should monitor the premium/discount to ensure they are getting fair value.
10. Issues of control
As passively managed investments, ETFs offer limited control over the underlying holdings. Investors cannot choose which stocks or assets are included in the ETF's portfolio. This lack of control can be a concern for investors who prefer a more hands-on approach to portfolio management. If you prefer to pick individual stocks, ETFs may not be the best option for you.
Key takeaways
ETFs are generally considered low-risk due to their low costs and built-in diversification by holding a basket of stocks or other securities.
For many retail investors, ETFs serve as a practical tool to create a well-diversified investment portfolio.
Compared to actively managed funds, ETFs often come with lower expense ratios, offer greater tax efficiency, and provide the option for automatic dividend reinvestment.
However, certain risks and tax implications can vary based on the specific type of ETF held.
Since ETFs track an index passively, they lack active management to mitigate downside risk, meaning they are fully exposed to market declines if the index underperforms.
Conclusion
ETFs offer benefits like cost-saving, easy trading, and diversification. However, it is important to consider the downsides, such as less variety and possibly higher trade costs. By carefully considering both sides, investors can make smarter investment decisions.
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