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According to the latest report from the World Gold Council (WGC), total ETF holdings worldwide rose for the tenth consecutive month in September, surpassing the 1,000-tonne mark for the first time ever in a calendar year.

By the end of September, gold ETF holdings increased by 68.1 tonnes ($4.6 billion) — or 2% of assets under management (AUM) — despite bullion’s worst monthly performance since November 2016.

Global net inflows of 1,003 tonnes ($55.7 billion) in 2020 have led overall gold investment demand and taken the gold ETF holdings universe to a fresh new all-time high of 3,880 tonnes and $235 billion in AUM, the Council notes.

Collectively, gold ETF AUM has grown about 67% year-to-date through September.

• Step 1: Markets > US > ETF

Step 2: ETF > Commodity > Gold ETF

Because of features like simplicity, low cost, low risks, etc., as we introduced last time, an ETF is still a popular investment alternative for many investors.

But are there any disadvantages of ETFs? 

Disadvantages of ETFs

For all that they offer diversification and the ability to track the index at very low cost, you should be aware of the below 5 issues before investing in them:

• Tracking error

Before you purchase an ETF, it's vital you know what underlying securities the ETF is tracking. Once you've done this, you have to accept some "tracking error", in other words, the ETF doesn't perform exactly how its underlying securities or benchmark perform.

• It's difficult to outperform

If you buy an ETF that tracks a major index such as the S&P 500 then your performance will be the same as that index (ignoring tracker errors) minus costs. This means that you won't outperform the index. You could, of course, go for more specialist ETFs such as a pharmaceutical or technology ETF but remember that technically ETFs are treated as mutual funds, which puts certain restraints on what they how they're permitted to operate. 

Over the last two hundred years, total returns from US equities have been nearly 10%, outperforming inflation by 5.5%. 

• Costs can be higher

Although they're not often cited as one of the disadvantages of ETFs, you should always look out for the costs!

ETFs have become a lot cheaper in recent years and now compare favorably to mutual funds. That said they will probably cost you more than individual stocks. That is because you will be likely to pay the brokerage fee when you buy the ETF and then there will be the ongoing management charge of the ETF while you own it. 

However, if you have a small portfolio and want a lot of diversification then ETFs that track major indices maybe cheaper as you'll effectively be able to own a piece of every company in that index whilst making one ETF transaction rather than buy every single stock, which would be both costly and impractical. 

ETFs could also lower your tax bill as you only pay capital gains tax when you sell an ETF. 

• Little control

When you own an ETF you have no say in what you own or what securities are bought and sold in the ETF you own. True they will stick to the parameters they set out (you won't get an ETF tracking financial companies that suddenly start buying tech companies) but they may start substituting out stocks that you would rather hold.

• Watch out for leverage

Some ETFs promise outsized returns by leveraging (borrowing) to purchase the underlying assets in an ETF. If a leveraged ETF has a 2:1 ratio then each invested dollar is matched by one borrowed dollar to invest. Technically this should magnify the gain or loss by the underlying asset by 2x but be careful: this often doesn't happen.

This is often due to the underlying fund leveraging by using futures contracts and can result in far higher costs and greater tracking errors. We think the use of leveraged ETFs is really for speculators rather than investors and would give a huge warning to anyone looking to use them. 

Conclusion

Despite the disadvantages of ETFs outlined above, we'd say that ETFs are of value to large groups of investors, if used properly. The key is to understand the risks we've highlighted above and try to avoid or minimize them.

Clearly if you love doing the groundwork of investing yourself then ETFs may not be for you. That said, if you are looking for a low cost way of replicating the stock market as a whole then a low cost ETF index tracker could be an excellent tool for you and, if bought consistently and regularly over a long period of time, should provide acceptable investment returns.