What Advisors Should Watch for—and Help Clients Steer Clear Of

Exchange-traded funds (ETFs) have never been more popular. Globally, assets under management (AUM) for ETFs surged by 27% in 2024 to a total of $14.6 trillion by year-end. And yet, although individual investors are sending record volumes of cash toward ETFs investments, there are still lingering and common misconceptions about ETFs.

Fortunately, financial advisors can play a crucial role in helping clients navigate the complex landscape of ETFs and avoid pitfalls as the ETF universe continues to expand.

Mistake #1: Misunderstanding How ETFs Are Structured

First, it’s essential that investing clients understand the basics of ETFs. When most retail investors think of ETFs, they likely think of them as passive products that track an index. These tend to be lower-cost funds with a straightforward mandate to track the benchmark’s return performance as closely as possible. Active funds, on the other hand, take a much wider range of approaches and may utilize systematic strategies, derivatives, buffer funds, and other tools.

For the individual investor, the passive fund approach is often the more approachable of the two. Still, investors should know that passive ETFs don’t necessarily mirror exactly the positions and weightings of an underlying index. Some may use an optimized sample of holdings or a more complex synthetic approach as well. Hence, it’s essential that investors closely monitor their ETF holdings, as well as any underlying indexes when possible.

Investors may also confuse ETFs and mutual funds. In addition to the distinction that most ETFs are passively managed while most mutual funds are actively managed, there is a key difference in trading as well. ETFs can be traded intraday like stocks, while mutual funds are purchased at the end of the trading day based on their net asset value (NAV).

Mistake #2: Chasing Performance

It’s common for investors to chase the ETFs with the highest recent returns, assuming that past performance correlates with future returns as well. Doing so can be risky, as numerous factors may cause the price of an ETF to rise. Without a solid understanding of those factors, attempting to time the market in this way is dangerous.

Instead, advisors should encourage clients to base their decisions on long-term strategy and due diligence, rather than short-term performance. Advisors with clients who tend to be overly active ETF traders can encourage them to hold leveraged and other funds designed for short-term trading in favor of “buy-and-hold” ETFs.

Mistake #3: Ignoring Fees and Liquidity

Many investors know that ETFs tend to have lower fees than other investment vehicles. It’s important to let clients know that there is a wide range of fees associated with different ETFs, however, and even low-cost funds have expenses. Clients should also understand that fees are automatically deducted and that they will not need to pay separately.

It’s easy for individual investors to disregard ETF liquidity and related concerns as well. However, liquidity can have a material impact, so it’s important that they recognize that bid-ask spreads exist for ETFs based on the differences between potential buy and sell prices, the costs of assembling and trading the fund’s securities basket, and more.

Clients should also be aware that there may be occasions when a fund’s market price differs from the NAV of its underlying securities. These premium/discount risks may vary among the various types of ETFs as well, which is important to bear in mind when weighing whether to invest in domestic or international funds, for example.

Finally, low liquidity may be a concern for niche ETFs in particular. Investors should watch for trading volumes and AUM levels in funds with highly specialized strategies or those recently launched. Ensuring adequate liquidity can help investors avoid negative impacts on their costs and trade execution, which can cut into their returns.

Mistake #4: Overconcentration or Overdiversification

Investors are drawn to ETFs in part because they are marketed as providing easy portfolio diversification. This is true, and it’s a significant benefit of some funds. However, ETFs also carry risks for inexperienced investors. Advisors should regularly monitor their clients’ holdings to ensure they have not unwittingly overlapped their exposure. This can occur when an investor holds positions in multiple funds with similar strategies or that include some of the same securities in their portfolios.

It’s also possible for investors to be overzealous in their ETF purchases, resulting in overdiversification. Spreading oneself too thin with too many funds can lead to a scattered and disorganized investment strategy. In these cases, advisors might encourage clients to consolidate their ETF holdings into a smaller number of funds.

Mistake #5: Missing Tax Implications

Another mistake many investors make regarding ETFs is being unaware of the tax implications. Financial advisors will want to be sure that their clients do not overlook capital gains distributions. For example, ETFs may occasionally distribute capital gains associated with the sale of some of their securities to shareholders, and these gains may have tax implications for investors in that fund.

Investors holding taxable and tax-advantaged accounts should ensure that they place their ETFs in the correct account. Putting a less tax-efficient fund in a taxable account, for example, may lead to higher taxes and, as a result, lower after-tax returns for that investor.

More active traders may inadvertently trigger wash-sale rules in the course of tax-loss harvesting. This is a concern for ETF investors as well as those targeting individual securities.

While there are other tax implications that ETF investors should consider, these are the ones that should be top of mind. A farsighted financial advisor can watch out for these and other tax issues and catch them before they hurt their clients’ investments and returns.

The Bottom Line

While ETFs are a powerful tool, they’re not “set-it-and-forget-it.” Advisors must help clients understand what they own, avoid common traps, and use ETFs thoughtfully to meet their goals.

Some of the most significant issues that ETF investors may be unaware of include the distinctions among different types of ETFs and between ETFs and other similar products like mutual funds, inadvertently chasing after the top-performing funds without paying attention to underlying factors, misunderstanding ETF fees and liquidity concerns and their impact on an investment, accidentally overconcentrating a portfolio by doubling up on exposure to certain securities or overdiversifying by investing in too many ETFs, and missing out on tax benefits or falling victim to tax pitfalls.