11 Weaknesses of ETFs: Actually, 90% Can Be Solved with a “Strategy”
In the previous two installments, I talked about what an ETF is and the mindset you should avoid when buying ETFs. This time, let’s look at the pros and cons of ETFs together.
All financial products are, in the end, just a “tool.” Whether a tool is good or bad depends on how the user uses it. If you use it incorrectly, you will naturally harm your own assets. That is precisely why you need to properly understand the pros and cons of this tool, and through that understanding and ingenuity, keep the impact of the disadvantages as small as possible.
The disadvantages of ETFs can be mitigated by strategy
There are a total of 11 disadvantages of ETFs that I will introduce from here on. You might feel anxious hearing that there are so many, but there are ways to reduce their impact. However, that requires a strategy. There is a proper strategy for buying and selling ETFs, and if you combine strategy and stock selection well, you can ensure the overall performance is solid.
I will divide the 11 disadvantages into four groups and match each with an improvement plan I have devised.
Group 1: Turning crises into opportunities to overcome ETF weaknesses
For a strategy of buying when the stock market is in a state of panic, you can refer to the “Nikkei Stock Average Volatility Index” and the “Fear & Greed Index (Japanese stock version)” for Japanese stocks (or the Fear & Greed Index for US stocks). The Fear & Greed Index (Japanese stock version) has a scoring method very similar to the US Fear & Greed Index, so you can use the US stock classification method as a direct reference. 0-25 points is extreme fear, 25-45 points is fear, 45-55 points is neutral, 55-75 points is greed, and 75-100 points is extreme greed. The “Nikkei Stock Average Volatility Index” uses the following guidelines: 0-10 is extremely calm (extremely low volatility), 10-20 is calm (low volatility), 20-30 is normal fluctuation (neutral), 30-40 is high volatility, 40-50 is intense fluctuation, 50-60 is extremely intense fluctuation, 60-70 is critical fluctuation, and 70 or higher is historical crisis-level fluctuation.
Please look at the figure below.
In other words, if the Fear & Greed Index for Japanese stocks is in the 0-25 range and the Nikkei Stock Average Volatility Index is 40 or higher, the market is in a state of extreme panic. If you buy ETFs at this timing, you can expect relatively good performance.
However, just because these two conditions are met does not mean that the ETF’s stock price will not fall any further. That is why you need to combine this with split purchases. We cannot be 100% certain how long the entire market will continue to fall. If you buy in installments, it becomes easier to avoid selling off an entire ETF just because of a short-term correction. Therefore, at the stage of selecting stocks, choose those that have confirmed stable growth in their past performance and are suitable for long-term investment. Then, by averaging your purchase costs through split purchases, you can lower risks such as difficulty in calculating a fair price or unclear growth rates.
Group 2: If the yield is unstable, look at other figures
It is true that ETFs are products where it is difficult for dividends to grow stably. However, there is a chance to encounter ETFs that can be expected to grow stably when evaluating stock prices and dividends together. To do that, you should look at dividend-inclusive returns or total returns. In other words, “it is better to look at total returns than to look at yield.”
Group 3: Whether it is a disadvantage or an advantage depends on the perspective from which you buy that ETF
The stocks included in an ETF are adjusted according to the rules set forth in the prospectus. However, precisely because those rules exist, it is impossible to make all the included stocks only excellent companies, and companies with poor performance are sometimes included. At the same time, since the rules in the prospectus cannot basically be changed freely, costs associated with such adjustments and costs caused by time lags in buying and selling are prone to occur in some ETFs.
However, when judging whether or not to buy an ETF, you need to accept a certain trade-off regarding these three points. These are certainly disadvantages for 100% value investors. But for people who cannot easily discern individual stocks or who want to invest in stocks outside their own range of knowledge, these three points are not disadvantages, but rather a kind of advantage in terms of risk diversification. In the end, it depends on the perspective from which you buy the ETF in front of you.
Group 4: I do not recommend bond-type ETFs
I do not recommend purchasing bond-type ETFs. Bond-type ETFs are not “bonds” themselves in the first place, and some even incorporate futures. Therefore, from the perspective of long-term holding, they are inevitably prone to being disadvantageous.
Do not underestimate these few advantages. This is where the true value of ETFs lies
Having looked at the 11 items so far, you might feel that ETFs have only disadvantages and few advantages. But in reality, the number of people investing in ETFs continues to increase every year. I believe this is because the advantages I am about to introduce carry that much weight.
Conclusion
So far, we have analyzed the pros and cons of ETFs and introduced improvement measures for the disadvantages. Have you, the readers, come up with a strategy different from mine? If so, please let me know in the comments section.
If you search online, you will find all kinds of ETFs, but researching them one by one seems like it would take a lot of time. Next, I will introduce an ETF filtering tool. In other words, I will talk about how to find ETFs worth researching from this vast ocean.
*The ETFs introduced in this series are strictly for illustrative purposes and are not recommendations or intended to encourage specific investment decisions. Please carefully consider stock purchases based on your own judgment.
Supplementary Materials and Tool Sites
Nikkei Stock Average Volatility Index:
https://indexes.nikkei.co.jp/nkave/index/profile?idx=nk225vi
Fear and Greed Index (Japanese Stock Version): https://jfgi.markets-lab.com/