Reviewed and Updated On: 6 Aug 2024
Investing in ETFs has become increasingly popular in recent years, and for good reason. One of the key advantages of ETFs is diversification, which allows investors to spread their risk across a variety of assets and sectors. However, like with any investment, there are pitfalls that ETF investors should be aware of and avoid.
In this blog post, we will discuss three mistakes that I made when I first started investing in ETFs and how to avoid them.
Mistake 1: Ignoring the costs
One of my biggest mistakes when investing in ETFs was ignoring their costs.
The two costs that you cannot ignore are the ETF’s expense ratio and the brokerage fees. While you might think that these costs are just a small percentage of your investment, the opposite of the magic of compounding works, too. Losing money due to high fees will negatively compound, impacting your returns over time.
To avoid this mistake, it is essential to understand the expense ratio of the ETF before you invest. An expense ratio above 1% is not ideal for a passively managed ETF. The more complex the exposure, the higher the expense ratio.
So, it would be best to compare the expense ratios of only ETFs that offer similar exposure. Comparing an S&P 500 ETF to a global ETF is not justifiable.
Another important step is always to check the fees you must pay the brokerage. Many brokerage platforms now offer zero commission fees, so it pays to shop around and find one that works for you.
Mistake 2: Investing in ETFs based on their name
Another mistake I made when I first started investing in ETFs was investing in them based on their name alone and not looking at their holdings. As the saying goes, “Never judge a book by its cover.” The same applies to ETFs.
For example, many ETFs that invest in emerging markets have “Emerging Markets” as part of their fund name. However, investing in these ETFs based on their fund name is disastrous as you do not know what defines emerging markets for these fund managers and whether there is a small allocation to developed economies.
Take a look at the Vanguard FTSE Emerging Markets ETF and iShares Core MSCI Emerging Markets ETF. Both ETFs have “Emerging Markets” as part of their fund name. However, if you investigate further, the geography allocation for both funds is widely different.
The iShares Core MSCI Emerging Markets ETF allocated 12% of its fund to South Korea, which the fund manager considers an “Emerging Market,” but not for the Vanguard FTSE Emerging Markets ETF.
To avoid this mistake, it is important to never make assumptions based on ETFs’ names. Instead, understand the underlying holdings of an ETF. This does not mean glancing through the holdings but instead researching the top 10-15 holdings and understanding the fund’s investing approach and index methodology.
As Peter Lynch, a renowned American investor, once said, “Know what you own and know why you own it”.
Mistake 3: ETF overlap
The third mistake I made when I first started investing in ETFs was ETF overlap. ETF overlap occurs when an investor owns different ETFs with similar exposures. For example, investing in $SPY and $VOO gives you almost the same exposure.
During market turmoil, holding similar ETFs will amplify your losses. ETF overlap also increases complexity, the concentration of investments, and risk.
To avoid this mistake, I use a free tool like the ETF Research Center Fund Overlap Tool to help me check for similarities. It provides details of the common holdings of any two ETFs by examining overlapping holdings. However, what is more important to look at is weightage.
In my opinion, more than 50% is a lot. This means that they share quite a few similarities.
Bottom line
In conclusion, investing in ETFs can significantly diversify your portfolio and spread your risk. However, it is essential to avoid common mistakes such as ignoring costs, investing in ETFs based on their name, and checking for ETF overlap.
By understanding the underlying holdings of an ETF, comparing expense ratios within similar ETFs, and checking for ETF overlap, you can minimise your risk and maximise your returns.
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