First let me say thank you to Chip and Jim for giving me the chance to contribute to greenfaucet.

For the six of you who have ever read my stuff you may know I tend to focus on ETFs along with a few other things like portfolio construction, managing portfolio volatility, market cycles and anything else that might come to mind.

 An ETF is a basket of....I know you are way beyond that.

I have been interested in ETFs since (AMEX: SPY) popped up in 1993 followed shortly thereafter by (AMEX: MDY). It was clear to me that ETFs would become a very big deal. As the industry has evolved we have seen a plethora of broad-based and narrow-based products list that range from being indispensable to being utterly useless. Do-it-yourselfers, provided they have the time to devote, can create some very sophisticated portfolios. 

With that sort of build up, what better time to point out some of the drawbacks.

ETFs might be all that and a bucket of wings but they are just investment products and like all investment products there are plusses and minuses. I happen to think the plusses outweigh the minuses but if you are going to use ETFs you probably need to explore the drawbacks.

I'll move beyond things like tracking error or higher fees on narrower funds and try to hone in on more strategic issues.

The first thing would be dividends. There is a statistic floating out there that says that something like 42% of the S&P 500's total return since 1950 has come from dividends. At times like when the market is up a little or down a little it makes sense to seek out a higher yield for the portfolio but that is very difficult to do with ETFs.

If you build portfolios by sector (which is what I do) you will find you can get much larger dividends from stocks than sector funds (obviously talking about sectors that usually are thought of as dividend payers).

You may be wondering well if that is the case what about WisdomTree's dividend weighted ETFs. I would tell you to take a look at what the funds actually pay out versus what the index yields (I'll write something up in a future post to explain this). I think the world of WisdomTree and use a couple of their funds but they don't actually pay as much as I thought they would.

Another portfolio issue is that not every segment of the market is covered by ETFs or the ETF for a particular theme might not provide access in a manner you would like. For example I've had exposure for clients to Sweden since 2003 (it has been a pretty good investment destination until very recently).

iShares has a Sweden fund with ticker (AMEX: EWD).  A few years ago EWD allocated 20% to Ericsson (NSDQ: ERIC) and I did not want that much volatility from Sweden so I went with a stock instead. Recently ERIC has struggled and now it only makes up 11% of the fund--meaning the biggest holding has been a big drag on returns.

Over that last few years I have had good luck investing in Norway (anything good for oil is good for Norway) but there is no ETF accessible in the US. If you like a theme are you going to skip it if there is no fund? Hopefully not. 

In accounts I manage I usually have 40-45 holdings in the equity portion of the portfolio of which maybe six or seven are ETFs. ETFs are great but they have drawbacks.