EXCHANGE-traded funds (ETFs) have been growing in popularity year-on-year over the past decade. But just like any investment, an ETF has its fair share of advantages and disadvantages. The real question, though, is whether ETFs are the right investment for you.

       A long-time follower of my column in The Star emailed to ask me questions about ETFs. He had just attended a talk by an Internet investment-trading platform.

       Feeling pumped up after the talk, he shared that he was convinced that ETFs were the best investment product ever invented. He was sold by the fact that ETFs offered low cost and diversification benefits conveniently.

       Spurred by this newfound “discovery”, he has decided to sell off all his existing investments in shares and unit trusts to invest only in ETFs. Sensing that he may not have a strong grasp of the investment, I set up a ZOOM meeting to offer him some views about ETFs.

       Generally speaking, ETFs are a suitable investment for you if you want diversification at a fraction of the price that you would usually pay for a well-diversified portfolio.

       This is because the average expense ratio of an ETF is lower than actively managed unit trust funds. Therefore, it confers cost-saving benefits.

       In addition, for very little cost, you can have access to stocks in certain countries or sectors without having to spend too much time selecting them. Like the iShare MSCI Hong Kong ETF for example, it covers many stocks listed on the Hong Kong stock market.

       Furthermore, a single ETF is made up of several individual securities in an index. Therefore, in terms of risk, it is more diversified and less exposed to company-specific risks.

       An ETF is a good investment vehicle if you want to gain exposure to specific sectors or markets that are harder to reach. For example, you can tap into China’s new energy sector or the US banking sectors. In fact, Canada, Middle East countries or Latin American countries are also within reach.

       ETFs are a good option if transparency is important to you. All actively managed ETFs are required to publish their holdings on a daily basis. Therefore, you would know exactly what you are investing in.

       ETFs are for you if you have the time and skills to research and select the right investment. There are more than 6,000 ETFs now in the world.

       You would need to know how to select the right ETF that would support your investment strategies. In other words, if you are new to ETF, you must be willing to invest some time and effort to research the investment in order to profit from it.

       Nevertheless, even though ETFs offer good diversification benefits, certain ETFs, like the technology sector, can be very volatile. Prices can swing by 20% to 30%. As such, to invest in an ETF, you must be willing to take the volatility into consideration and be prepared to stomach the risk.

       On the other hand, an ETF is not a suitable investment for you if you want to achieve higher returns than what the index can offer. Most ETFs are passively managed to produce a return that replicates the underlying index. They can only give you the index return.

       To get higher than index returns, you need to invest in stocks directly or leverage on the expertise of unit trust fund managers in certain markets to outperform the index.

       If you want to avoid certain stocks in the index, ETFs are not suitable for you. Investors do not have a say in the individual stocks in an ETF’s underlying index.

       This means that an investor looking to avoid a particular company or industry does not have the same level of control as an investor focused on individual stock investing. For example, you may want to cut back on exposure to a particular stock, or that you only wish to focus on stocks that are syariah-compliant.

       Warren Buffett, one of the great investors of our time, has been a strong proponent of the S&P500. It has led many people to think that they can put all their money into S&P index ETFs and nothing else.

       But are you aware that history has shown time and time again in many 10-year periods that a globally diversified portfolio can also achieve an investment return as high as the S&P index, and with a lot less risk?

       Therefore, if you are thinking of buying only one ETF and not building a diversified portfolio, that idea may not work in real life.

       Meanwhile, many people who claim they can tolerate prolonged stock market slumps discover they really can’t. Just ask all the folks who sold in 2020 as the markets fell. Most didn’t have the stomach for the volatility and had to sell low, incurring big losses in the process.

       The same year, hundreds of thousands of people lost their jobs or failed in business, causing them to liquidate their investments due to an unprecedented pandemic. Many witnessed their long-term horizons evaporating right before their eyes

       Therefore, while history shows that the stock market has been the best-performing asset class over long periods, you don’t live in a spreadsheet. You live in the real world, and life gets in the way sometimes. That’s why you need to diversify – in case you must interrupt your long-term strategy.

       ETFs may not be the ideal investment for you if you believe in using the best of breed strategy to access designated asset classes.

       Historically, ETFs had not been shown to perform well in all markets.

       In developed areas like the United States and European markets, ETFs are way more efficient compared to Asian markets (where there is a lower chance to outperform the benchmark over the long term), making it difficult for unit trust funds to generate alpha (additional returns from the average market returns) against the market.

       In contrast, unit trust funds tend to perform better in less-efficient developing markets. For example, unit trust fund managers in Malaysia and China are typically able to outperform the index and ETFs.

       That’s because in these markets, the fund managers are still able to discover opportunities from fundamental or technical analysis to determine undervalued or overvalued stocks to increase their chances of making higher than market-average returns.

       ETFs would not be ideal if you are not a disciplined investor.

       One of the most advantageous aspects of investing in an ETF is the fact that you can buy it like a stock. However, this also creates risks that can hurt your investment return. Why? It can change your mindset from an investor to an active trader.

       Once you start trying to time the market or pick the next hot sector, it is easy to get caught up in regular trading.

       Regular trading adds cost to your portfolio, thus eliminating one of the benefits of ETFs – low fees.

       The cost of an ETF is relatively low. However, as more niche ETFs are created, they are more likely to follow a low-volume index.

       This could result in a high bid/ask spread and increased cost. In addition, an actively-managed ETF also charges higher fees. Before 2005, the expense ratio of all previously issued ETFs averaged 0.4%, according to Morningstar.

       Since 2005, the average expense of new ETFs has jumped to over 0.6%, while some of the new ETFs are charging over 1% in fees.

       ETFs offer diversification benefits. However, just because an ETF contains more than one underlying position, it doesn’t mean that it can’t be affected by volatility.

       If you are expecting capital guarantee and fixed-income stream, ETFs are not for you. The magnitude of volatility will mainly depend on the underlying securities.

       An ETF that tracks a broad market index such as the S&P 500 is likely to be less volatile than an ETF that tracks a specific industry or sector such as an oil services ETF.

       Every time you add a single country fund, you increase the risk.

       If you buy into a leveraged ETF, you are amplifying how much you will lose if the investment goes down. So, not all ETFs are the same, as are their risk.

       ETFs are not a perfect an investment as most people think. At best, an ETF can be used to enhance one’s investment portfolio, but it should not be taken as “a be all and end all” solution to achieve your investment objective.

       At any given time, don’t rush into any new investment based on the face value. You owe it to yourself to learn more about the investment before parting with your hard-earned money.

       If you want to be sure that you are using the investment properly, it is always wise to consult with a licensed financial planner.

       Yap Ming Hui is a licensed financial planner. The views expressed here are the writer’s own. Any reliance you place on the information shared is therefore strictly at your own risk.