ETFs have many benefits, including their low expense ratio, being diversified, and they track market indices by just one fund.
So do ETFs have any drawbacks?
Coming Up with An Index is An "Active" Process
For example, the S&P 500 index has to follow some rules when adding or removing stocks. According to Investopedia,
to be eligible for S&P 500 index inclusion, a company should be a U.S. company, have a market capitalization of at least USD 13.8 billion, be highly liquid, have a public float of at least 10% of its shares outstanding, and its most recent quarter’s earnings and the sum of its trailing four consecutive quarters’ earnings must be positive.
When an index follow a certain rule to adjust its component stocks and an passive ETF has to follow the same rule in order to track it, the ETF would act just like an active fund that rigorously follows some investment strategy.
There might be Unnecessary Cost
That an ETF blindly follows a set investment rules might cost unnecessary cost that may not include in its expense ratio. This unnecessary cost results from the ETF's turnover ratio. According to ETF Database:
he more times an ETF churns its portfolio, the more in fees the fund is racking-up. What’s more is that these transactional brokerage fees are not included in the calculation of a fund’s operating expense ratio listed in the fund’s prospectus. These costs in a high turnover portfolio can be a pretty significant additional expense. One that ultimately, reduces investment returns.
Few Actively Funds have Better Returns Than the Passive Ones?
It is fair to say when an ETF beats the other, it's actually the index that beats the other one.
In this case, anyone can come up an index with some composite rules and compare this index with other ones, which is just like comparing actively managed funds.
So it is not the active ETFs being compared with the passive ones, it's the indices who are compared with one another.
For example, VTI can beat VOO, or the other way around, I am not 100% sure which is better.
That Too People Blindly Invest in Passive ETFs Could Create Stock Market Bubbles
That people blindly buy passive ETFs such as SPY, IVV and VOO which track the S&P 500 index could create stock market bubbles.
>An analogy is as follows.
Passive ETF, AppleETF, tracks Apple stock returns absolutely. When AppleETF is just founded, it has $100 in the fund. Suppose Apple stock price is $100 the same day AppleETF is founded, in order to absolutely track Apple stock's returns, AppleETF has to spend all its cash to buy Apple stock which is traded at &100 a share. AppleETF has $100 cash and 1 share of Apple stock is $100, so AppleETF buys 1 share of Apple stock on the first day it's founded.
The next day Apple's stock price rises to $200. Because AppleETF has 1 share of Apple stock, its value grows to $200, too.
If on the second day, one person invest in AppleETF with $200, what will AppleETF do in order to keep tracking Apple stock's returns. It will have to immediately spend all its cash at hand to buy Apple's stock.
What if it doesn't?
The third day, Apple stock price rises to $400, if AppleETF has not bought a share of Apple's stock the previous day, its value will be $600(1 original Apple's share and $200 cash a person puts in on the second day). If the person who invests in AppleETF bought Apple stock directly, he or she should have a 100% return(from $200 to $400). But now, AppleETF only generates a 50% return($400 on the second day to $600 on the third day).
In Reality
ETFs are exchange traded, so when people pour money in an ETF, the ETF may be traded at a premium, and Its issuing company may issue more of the ETF’s units to make a profit. Then, the ETF issuing company would need to buy the tracked index’s component stocks so that the newly issued units can be properly represented by the index.
So?
An passive ETF might have to blindly buy in the tracked index's component stocks in order to keep up with the index's returns. When a lot of money is poured into the stock market with no regard of whether or not the stock market is too high, stock market is pushed higher. This might result in a stock market bubble.
Investopedia. The S&P 500: The Index You Need To Know. www.investopedia.com/articles/investing/090414/sp-500-index-you-need-know.asp. Accessed July 24 2021.
ETF Database. Portfolio Turnover 101: An ETFdb.com Guide. etfdb.com/etf-education/portfolio-turnover-101-an-etfdb-guide. Accessed July 24 2021.
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