Fees matter when choosing an investment, but it’s not the only factor to consider. That’s particularly true with exchanged-traded funds or ETFs, which already are cheaper than many other funds on the market. Consider this: according to the Wall Street Journal ETFs on average have an expense ratio of 0.44%. That compares to the average index fund’s expense ratio of 0.74%. That doesn’t mean every ETF is cheap, but the majority of the most mainstream ones tend to be. (Read more, here: Minimizing ETF Fees.)
Nonetheless, many investors choose to harp on the fees, spending hours upon hours poring over the prospectus, looking for hidden or extra fees when deciding which ETF to invest in. They figure every penny that goes to fees and expenses means less money being invested. And while due diligence is the cornerstone of any sound investment decision, that same discipline often isn’t applied to the makeup of the ETF. After all, it's tracking an index anyway, so how much attention really needs to go to the underlying investments, is often the line of thinking. That could increase as more 401k plans include ETFs. Studies showemployees give more thought to planning a vacation than choosing their 401k investments.
It turns out the investments matter more than investors may think. Not paying attention to the underlying investment can throw a portfolio off track, which means it’s not working as planned. From having the proper asset allocation to preventing redundancy, here’s a look at why fees shouldn’t be the only factor to consider when choosing which an ETF to invest in.
Focus Only On Fees Limits Choices
ETFs have exploded in popularity, appealing to risk-averse investors who don’t want to pay a lot for their investments. That means investors have a lot of choice regarding the makeup of the ETFs, giving them the ability to create a diversified portfolio. (Read more, here: 6 Popular ETF Types For Your Portfolio.) But for extremely price-conscious investors, focusing on the fees will limit their choices and thus their diversification and potentially their returns. Investors who don’t take the time to look at what the stocks are in the ETF could end up with ones that are industries that are facing negative headwinds like oil stocks or funds with high turnover that means more of a tax hit. Sure there may be cheap oil-focused ETFs, but the money you save in fees won’t mean much if oil prices continue to sink. Some ETFs are pricier for a reason. There are exotic ones that are going to cost more but give risk-seeking investors access to different types of investments.
Redundancy Costs Investors
Investors can’t put all their eggs in one basket, even when investing in ETFs. They have to have diversification, which means investments across different industries and regions. It also means a mixture of both safe and risky bets. For the portfolio to work, it has to match your investment horizon and risk tolerance. ETFs can play a role in achieving that, but that’s only if you take the time to look at the investments. A mid-cap focused ETF and global-focused ETF may seem different, but there could be overlap in the investments. Too much overlap means less diversification, which spells trouble. Because the investor didn’t look at the makeup of the ETF before investing the asset allocation could shift too much, impacting the risk tolerance and thus your overall investment plan. (Read more, here: How To Pick The Best ETF.)
The Bottom Line
ETFs are a low-cost way for investors to create a diversified portfolio. Paying attention to fees matters, but it’s not everything. Investors have to be mindful of their investment choices making sure it matches with their risk tolerance and investment goals before choosing which ETF to invest in.