By Peter S. Kraus We don’t hate ETFs . In fact, we use them ourselves and are considering managing client assets in the active ETF space. When used properly, these instruments can be a useful component in a well-diversified portfolio. But ETFs aren’t perfect, and relying heavily on them without understanding their imperfections is risky. ETFs have structural limitations that need to be addressed. We worry that the vast amount of money invested in these instruments – close to $3 trillion globally – may have created risks that investors don’t appreciate. The asset management industry has an obligation to educate investors about these risks. We don’t think it has done that job well enough. ETFs were created as a tool for sophisticated institutional investors and traders to use to get short-term tactical exposure to a given market. They were well-suited for this purpose because they could be bought and sold at any time, just like individual stocks. We still think using ETFs for short-term, tactical purposes makes sense. More recently, however, ETFs have become popular with smaller, less experienced investors. In many cases, they have become the mainstay of these investors’ portfolios. This concerns us, because certain ETFs can damage investors’ portfolios – particularly when investors don’t fully understand how they work. Market liquidity has changed significantly since the 2008 financial crisis. ETFs – both active and passive – are not immune to the dangers this new liquidity environment poses. However, we worry that many investors have embraced ETFs because of their perceived liquidity – which in some cases can be an illusion. The plunge in global equity markets on August 24 was a case in point, when US exchanges halted trading in certain stocks that morning. But many ETFs continued to trade, and without good pricing information, 10 of the largest equity ETFs traded at a steep discount to their underlying value. In other words, the ETFs’ prices collapsed far more than the prices of their underlying securities. If you had tried to sell during that period, you could have experienced a significant loss. Sophisticated institutional investors would probably have known to use a “limit order” when selling in those conditions. It’s unfair to expect the average retail investor to have the same level of understanding. In fact, if a product requires limit orders, should it even be marketed to smaller investors in the first place? At the very least, we think these events should make investors question just how deep the ETF liquidity pool really is. And we’re not the only ones voicing these concerns. SEC Commissioner Luis Aguilar said the August events mean “it may be time to re-examine the entire ETF ecosystem.” Others, including Federal Reserve Vice Chairman Stanley Fischer, have raised similar issues. Liquidity Concerns In High Yield, Emerging Markets In other markets, ETFs are even less efficient – and less liquid. Yet, we worry that investors continue to pour money into them without a full understanding of the risks. Think about it this way: More and more investors are turning to ETFs in relatively less liquid markets like high-yield bonds and emerging markets. To meet that demand, these funds must hold an ever larger share of less liquid assets. If the underlying asset prices were to fall sharply, finding buyers might be a challenge, and investors who have to sell may take a sizable loss. Not Always As Cheap As They Look Then there’s the issue of cost. Passive ETFs passively track an index. This style of ETF investing should keep a lid on costs. Financial advisors who use ETFs as core holdings in their clients’ portfolios often tell us this low fee is why they do so. It’s true that some ETFs that invest in the most liquid assets, such as large-cap equities or government bonds, carry much lower management fees than mutual funds. But some other types of ETFs really aren’t that cheap. Take high-yield bonds, where ETF expense ratios can be as high as 0.5%. For emerging market stocks, they can be close to 0.7%. That’s not far from the average active mutual fund fee. Here’s what is different: performance. Since 2008, the biggest high-yield ETFs have underperformed the average active manager and the broad high yield market, not to mention their own benchmarks. Hidden Costs, Less Flexibility ETF costs can be high for many reasons that investors don’t see. For example, in less liquid markets, bid-ask spreads – the difference between the highest price buyers are willing to offer and the lowest that sellers are willing to accept – widen sharply when trading gets volatile. High-yield ETF managers can rack up high trading costs because bonds go into and out of high-yield benchmarks often – certainly more often than stocks enter and exit the S&P 500. Here’s something else to consider: the high opportunity cost of not using active management. ETF returns often suffer because these instruments passively track an inefficient index. That means they can’t pick and choose their exposures based on a security’s individual risk and return characteristics, the way active managers can. Investors learned this the hard way when oil prices plunged and took high-yield energy bonds – a large component in high-yield indices – and many emerging-market stocks and bonds down with them. Active managers who saw the warning signs of rapidly growing debt and leverage in this sector could have strategically reduced exposure and exploited these inefficiencies at the time. Look Before You Leap So what’s best for investors? Should they ditch ETFs altogether? Of course not. Certain ETFs have a place in a well-diversified portfolio – but they’re no panacea. It’s critically important that investors know what they’re signing up for when they buy them. And it’s time for asset managers to step up and explain the fine print. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.