Much has been said in the media about the benefit of Exchange Traded Funds (ETFs). But like all financial products, there are situation which its purchase is not suitable. So here are a few scenarios in which investing in Exchange Traded Funds may not be suitable.
When the focus is not large cap
There are countless number of Exchange Traded Funds all over the world. But very few really make sense. This is because a large proportion of these ETFs have issues such as tax inefficiency, poor liquidity and marketing gimmicks (like smart beta). You will find that those make sense are ETFs that mirror after large cap indices.
Therefore, if you are NOT looking for large cap investment, you may find that it is very hard to find an ETF that suit your needs.
When the focus is dividend payout
The dividend yield of a typical large cap ETF is very low. Sometimes almost nothing. So if you are looking for dividends, ETF is not the way to go.
This brings me to the next related point…
When the focus is to provide a retirement income
Since a typical large cap ETF produces very little dividend, you cannot rely on it to receive an income to support your retirement years. The portfolio size required will be too large.
Take for example, if the dividend yield is just 2% and you need $60000 a year of dividend income, you will need 60000/0.02 = $3m. If the dividend yield is 5%, the portfolio size required is just 60000/0.05 = $1.2m.
There are ETFs that focuses in investing in companies with high dividends. But the dividend yield is around 3.5%pa only. So the portfolio size required is still quite large.
When there is a need to sell down the capital over a period of time
Most retirees have to sell down their investment portfolio over a period of time because their investment portfolio is not large enough to provide a perpetual income.
If the retiree need to sell down the ETF portfolio regularly, there is a danger of looking at their portfolio too frequently. This creates a few problems:
- The frequent need to view and manually sell the portfolio could create a trading mentality. This may lead to high trading cost.
- For a retiree who has nothing else to do, such trading mentality may result in addiction. This is a very common phenomenon. The trading behavior can evolve to become a gambling addiction.
- Due to the rapid decrease in mental capacity, the retiree may eventually be unable to sell. A person without mental capacity may not have the ability to make investment decision such as redemption.
- The need to review the portfolio regularly due to the need to manually sell could results in making irrationale decision such as redeeming the entire portfolio during a severe market crash.
When rebalancing is important
If there is a need to rebalance the portfolio regularly, ETFs will run in the problem of high trading cost. This is similar to the problem of holding stocks. That’s why people who invests in stocks do not rebalance because they don’t know how or it is just too costly and troublesome to do so.
When there is availability of low-cost index fund
I found out that most people do not know the difference between index funds and ETFs. They are not the same. The latter is traded on the stock exchange like a stock while the former is purchased over-the-counter and has only one trading price each day.
The short and long term cost of index fund is actually lower compared to ETFs. So for those who has access to index funds, they should not invest in ETFs. From estate and tax planning point of view, index funds are also potentially more superior compared to ETFs.
When overweight in bonds is required
For those who need to overweight bonds, getting a bond ETFs is not recommended. The reason is because bonds tend to have a rather low return but comes with lower risk. If the bond ETFs have foreign currency risk, the low return derive from bonds are likely to be wiped out but the risk level increases. Most bonds ETFs have currency risk.
Other comments on ETFs
Some financial planners advocate the creation of multiple portfolios with varying time horizon in order to overcome some of the problem above.
The use of multiple portfolios is fine for younger investors but not recommended for retirees due to the complexity involved for multiple portfolios.
I deliberately write this article which seemingly contradict many of my articles on the benefits of ETFs. I do this for a reason.
My purpose of writing blogs is for educational purpose. But the intention was never as a prescription and I do not expect people to take my articles as financial advice. I expect people to seek financial advice. Even if it is not from me, at least from someone licensed to give that advice.
Over the years, I was shocked to have discovered people who read my blogs and to take these articles as financial advice. Last year, one person told me that he has been following my blog for nearly 9 years and have followed what I wrote investing a huge portion of his networth based on my blog. I was very trouble by what he did. He should have obtained proper financial advice. At least, he should have approached me 9 years ago before embarking on such important decision. What happens if he loses a huge portion of his money? Although I am protected by my site’s disclaimer statement, people must spare a thought of how insecure I feel knowing that the intended educational purpose of the articles have become a prescription to cure all sort of “sicknesses”.
Imagine if this blog is about educating people about the benefit of exercise. What would happen if people starts to follow the exercise methods written in the blog thinking it as the cure for their illnesses? These exercises could actually kill them! The right approach is to seek professional help from their doctors!
All financial products come with advantages and disadvantages. There is certain situation which they are not appropriate. My thoughts of financial planning are written without specific persons in mind. Hence, people should seek advice from their advisers.
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