Investing in broad market ETFs can seem like a rock-solid strategy, especially with their ability to diversify risks across a wide range of stocks. However, not everything that glitters is gold. Let’s talk about what could go wrong. Market volatility is perhaps the most obvious risk. You may remember how the S&P 500 plunged by about 34% between February and March 2020 during the COVID-19 pandemic. A broad market ETF tracking the S&P 500 would have mirrored that nosedive. So, even though these funds spread risk, they’re not immune to significant downturns.
Then, there’s the question of management fees. While broad market ETFs often boast lower expense ratios compared to mutual funds, these fees aren’t zero. For instance, a seemingly modest 0.04% annual expense ratio might not sound like much. However, over a $100,000 investment held for 20 years, that could equate to about $8,000 in fees, assuming a consistent 7% annual return and fees compounding annually. Better believe that bites into your profits.
Many investors see dividends as a route to steady cash flow. However, broad market ETFs sometimes deliver less in the dividend yield department compared to more specialized funds. For example, you might be able to fetch a 4-5% yield with a high-dividend ETF, while a broad market ETF more likely offers around 2% annually. The more modest income stream may not cut it for those depending on their investments for regular earnings.
Economic downturns can also expose investors to broader market risks. Recall the 2008 financial crisis. Most ETFs mirrored the overall market meltdown, plummeting by nearly 40% by the end of that year. A diversified approach cushioned the fall somewhat, but it didn’t fully protect against the immense downward pressure affecting all sectors.
Let’s consider industry disruptions. Market dynamics can have more detrimental impacts on certain sectors. When new regulations hit or innovations disrupt an industry, broad market ETFs are unable to shield investors from sector-specific declines. For instance, during the tech bubble burst of 2000-2002, tech-heavy indices and related ETFs suffered severely. While other sectors in a broad market ETF might have fared better, the heavy losses in one heavily weighted component diluted the benefit.
Market capitalization weightings form another concern. Broad market ETFs often tilt towards larger companies due to their market cap structure. This slant can lead to overexposure in big-name stocks. You’d be doubling down on giants like Apple, Microsoft, and Amazon. These companies may wield immense market influence, but their financial troubles or lower-than-expected earnings can drag the ETF’s performance down significantly. The idea of diversification loses its strength when a few large companies’ performance dictates the fund’s overall results.
Currency risk poses a subtle threat to those investing in international broad market ETFs. Exchange rate fluctuations can significantly impact returns. Say you invest in a world index fund; a strengthening US dollar against foreign currencies will reduce the value of your international investments. That’d be like having a rug pulled out from underneath when you’re least expecting it.
You might think broad market ETFs reduce individual decision-making pressure. While that’s mostly true, the reality isn’t so simple. Broad market ETFs offer no possibility for personal stock picking or tactical adjustments. If you spot a downtrend in, say, the oil industry but hold a broad market ETF that includes energy stocks, you can’t carve out the exposure you wish to avoid. In other words, you get the whole pie – even if some slices are sour.
Trading costs can further chip away at your returns. Frequent trading can rack up transaction fees, especially if you’re moving in and out of positions. Even if your broker offers commission-free trades, the bid-ask spreads can cost you, particularly with less-liquid ETFs. These spreads may not be as pronounced with the most popular broad market ETFs but can still sneak up on you.
Psychological factors also carry weight here. Broad market ETFs can create a false sense of security. Overconfidence or complacency might cause you to overlook essential portfolio reviews or miss signs that call for a shift in your investment strategy. Assuming that your investments are ‘set and forget’ could be a costly mistake.
So, are broad market ETFs flawless? Not quite. Despite offering diversified exposure and relative stability compared to individual stocks, they come with their own set of risks that investors should not ignore. Click Broad Market ETFs for more on the potential upsides of these financial tools. But remember, investing in them requires just as much due diligence and strategic thought as any other investment vehicle.