The market for exchange-traded funds (ETFs) has grown dramatically over the past decade, as investors have sought greater diversification at a reduced cost. While ETFs offer plenty of upside, they are not immune to risks and costs. Investors who seek to maximize their success in the ETF market while keeping danger at bay must become familiar with these risks to ensure longevity in the market.
ETFs are often considered much less risky than other asset classes because they allow for broad diversification of stocks and bonds at a fraction of the cost. There are literally thousands of ETFs to choose from, and many are comparable to traditional index funds.
Used correctly, ETFs are a powerful tool for building wealth. However, many investors enter into ETFs thinking they can set their portfolio to autopilot without evaluating the risks and rewards of the market. This is not a recipe for success, regardless of whether you manage your portfolio actively or passively.
Warren Buffett, widely regarded as the greatest value investor of all time, always says that he is a fan of passive investing, but that he manages his portfolio actively. He has also famously stated, “I’d be a bum on the street with a tin cup if the markets were always efficient.”
For ETF investors, this means being aware of your risks and costs regardless of your underlying portfolio strategy. This is especially important in today’s environment, where many investors are relying solely on ETFs to drive their portfolio. This strategy, referred to as ‘ETF Wrapping’, can leave many investors exposed to undue risks. In the following, we outline what those risks are and how to avoid them.
The Ten Risks of ETF Investing
1. Market Risk
Like other asset classes, ETFs face market risks. Since they are only a wrapper for their underlying investments, ETFs cannot avoid the fates of the market they track. While ETFs provide numerous advantages that can help investors mitigate risks, nothing will stop them from going down if their underlying assets are falling.
Market risks are one of the biggest costs of trading and cannot be mitigated directly. Rather, investors should allocate capital in their portfolio in a way that reduces exposure to any one asset or risk.
2. Trading Risk
Trading risk refers to the total cost of owning an ETF portfolio. ETFs have been described as tax efficient, transparent and cheaper when compared to other asset classes. However, they still entail costs in the form of commissions, sales charges, market impact costs and direct trading costs, such as the bid-ask spread and management expense ratio.
ETFs may also suffer from crowded trade risks, given the sheer number of market participants involved in this market. Like other assets, ETFs also carry opportunity costs, creation and redemption fees and taxes on interest income and capital gains. These fees must be factored into overall trading costs so there aren’t any surprises down the road. To ensure high quality trade execution, be sure to read Six Best Practices for Executing ETF Orders.
3. Liquidity Risk
From the perspective of ETFs, liquidity is often misunderstood. Since ETFs are at least as liquid as their underlying assets, trading conditions are more accurately reflected in implied liquidity rather than the average daily volume of the ETF itself. Implied liquidity is a measure of what can potentially be traded in ETFs based on its underlying assets.
This is very different from average daily volume, which provides a historical account of how frequently the ETF is traded. Investors who have in the past relied on average daily volume to gauge liquidity need to reassess their strategy for the ETF market.
4. Composition Risk
Composition risk refers to the fact that indices, and the ETFs that track them, aren’t interchangeable. While two ETFs may track the same index or sector, their performance may not be equal due to different holdings in the underlying basket. For example, two ETFs may track the healthcare industry, but rely on a completely different basket of companies or segments.
Examples include the iShares U.S. Medical Devices ETF (IHI ) and the Health Care Select Sector SPDR (XLV ). Assuming all ETFs that track a specific sector will perform well overlooks vital features of the ETF basket itself, such as the lineup of securities included and their individual weightings.
Additionally, exotic securities that move away from plain vanilla stock and bond ETFs could create unwanted exposure that leads to volatility. This is especially the case with leveraged ETFs.
To learn more about ETF composition and what it means for your portfolio, read The 7 Different ETF Structures.
5. Methodology Risk
ETFs are not all created equal, even those that track the same market or sector. For example, the Direxion Daily Financial Bull 3x Shares ETF (FAS ) provides three-times leverage on the Russell 1000 Financial Services Index, but won’t return 300% of its benchmark’s returns. The U.S. Oil Fund (USO ) is an oil fund, but doesn’t directly track the price of crude.
Methodology risks aren’t always easy to see, which means investors need to read the fund prospectus to understand the nuances of the investment strategy, including its holdings and weightings.
6. Tracking Error Risk
Tracking risk occurs when an ETF does not mimic or follow the index it is tracking due to a combination of management fees, tax treatment and dividend timing. ETFs that use physical replication exhibit larger tracking errors compared to ETFs that use synthetic replication. Investors need to be aware of this difference when selecting ETFs with physical replication. A synthetic ETF is designed to replicate the return of a selected index via financial engineering. Examples of synthetic ETFs include the UltraShort Gold ETF (GLL ) and the VelocityShares 3x Inverse Gold ETF (DGLD ).
Use our Head-to-Head Comparator tool to compare these and other ETFs along various criteria, such as performance, AUM, trading volume and expenses.
7. Counterparty Risk
In general, counterparty risk comes into play when dealing with securities lending and synthetic replication. In the case of securities lending, counterparty risk is seen when holdings are lent to another investor for a short period. This risk can be minimized by establishing collateral requirements. In the case of synthetic replication ETFs that track indices via swaps, risks can be mitigated by collateralizing the fund’s swap exposure. This leads to higher risk, but investors are compensated for this by being offered lower tracking error and lower fees compared to their physically backed peers.
Counterparty risk comes into play when dealing with exchange traded notes (ETNs), which are essentially unsecured debt notes issued by a bank. When trading ETNs, investors can essentially be hung out to dry in the event the bank goes bust. While this alone shouldn’t deter investors from using ETNs, it should make them cognizant of the risks involved. Examples of popular ETNs include the iPath S&P 500 VIX Short-Term Futures ETN (VXX ) and the VelocityShares Daily Inverse VIX Short-Term ETN (XIV ).
8. Tax Risk
ETFs are widely considered to be tax efficient, but this doesn’t apply to all of them. It’s important for investors to read up on a fund’s tax treatment, especially if it’s exposed to commodity and currency markets. These funds are usually taxed differently than others.
ETFs typically do in-kind transactions to avoid paying capital gains distributions. However, actively managed ETFs may not do all their selling in-kind, leaving investors exposed to capital gains taxes. This also applies to international ETFs, funds that use derivatives, commodity ETFs and currency ETFs.
9. Closure Risk
On average, about 100 ETFs close each year. When this occurs, managers liquidate the fund and pay out their shareholders. Managers incur capital gains, transaction expenses and in some cases legal expenses, which ultimately trickle down to the investor. Closure risk is part and parcel of being an active market participant.
Investors should sell an ETF as soon as the issuer announces it will close.
|Type of Structure||Short-Term Tax Rate||Long-Term Tax Rate||Additional Information|
|Grantor Trust: 39.6% Limited Partnership: 28% ETN: 39.6%||Grantor Trust: 28% Limited Partnership: 28% ETN: 20%||Distributes a K-1 form (Limited Partnership)|
|Open End Fund: 39.6% Grantor Trust: 39.6% Limited Partnership: 28% ETN: 39.6%||Open End Fund: 20% Grantor Trust: 28% Limited Partnership: 28% ETN: 20%||Distributes K-1 form (Limited Partnership)|
10. Hype Risk
Hype risk often feeds into herd mentality, where investors chase the next big thing because fellow market participants are doing the same. ETFs are all the rage these days, which means many funds are propping into existence. Buzz is bound to happen. While exuberance is to be expected in a bull market, investors should be wary of chasing the so-called “next big thing.” This means sticking true to your investment strategy and studying each ETF’s methodology and documentation.
For a deeper analysis on individual ETF investments, use our ETF Analyzer tool. You can select ETFs by Category or Type as well as add individual ticker symbols to compare performance, expenses, and dividend yield among other metrics.
The Bottom Line
Investing in ETFs can be much more profitable by mitigating these ten risks. By understanding the market and its subtle nuances, investors will be better prepared to enter this fast-growing market.
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