The booming market for exchange-traded funds draws investors seeking greater diversification at a reduced cost.
Despite their abundant upside, however, ETFs are not immune to risks and costs, and investors must be aware of these to ensure their longevity in the market. Used correctly, ETFs are a powerful tool for building wealth.
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. But according to an article published Tuesday on ETFdb.com, many ETF investors think they can set their portfolio to autopilot without evaluating the risks and rewards of the market.
This will not lead to success, regardless of whether the portfolio is managed actively or passively.
The article stresses that ETF investors must enter the market with open eyes. “This is especially important in today’s environment, where many investors are relying solely on ETFs to drive their portfolio.”
It says this strategy, referred to as “ETF wrapping,” can leave many investors exposed to undue risks.
Following are 10 risks of ETF investing outlined by ETFdb and how to manage them:
1. Market Risk
As ETFs are only a wrapper for their underlying investments, they cannot avoid the ups and downs of the markets they track. Although they provide investors many advantages that can help mitigate risks, nothing will stop them from declining if their underlying assets fall.
Market risks are one of the biggest costs of trading and cannot be mitigated directly, ETFdb says. Rather, investors should allocate capital in their portfolio in a way that reduces exposure to any one asset or risk.
2. Trading Risk
Seen as tax efficient, transparent and cheaper than other asset classes, ETFs still entail costs in the form of commissions, sales charges, market impact costs and direct trading costs.
And because of the large number of participants in this market, they may also suffer from crowded trade risks. Like other assets, ETFs also carry opportunity costs, creation and redemption fees, and taxes on interest income and capital gains, which must be factored into overall trading costs to avoid any future surprises.
ETFdb offers a list best practices for executing ETF orders.
3. Liquidity Risk
It behooves investors to understand liquidity from the perspective of ETFs. 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 fund itself, which only provides a historical account of how frequently the ETF is traded. Implied liquidity is a measure of what can potentially be traded in ETFs based on underlying assets.
ETFdb says investors who in the past have 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 indexes, and the ETFs that track them, are not interchangeable. Two funds may track the same index or sector, but their performance may not be equal because of different holdings in the underlying basket, for example, iShares U.S. Medical Devices ETF (IHI) and Health Care Select Sector SPDR (XLV).
ETFdb says investors who assume all ETFs that track a specific sector will perform well overlook vital features of the ETF basket itself, such as the lineup of securities included and their individual weightings.
Moreover, 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, according to ETFdb.
5. Methodology Risk
ETFs are not all created equal, even those that track the same market or sector. For example, U.S. Oil Fund (USO) is an oil fund, but doesn’t directly track the price of crude.
Because methodology risks are not always easy to spot, 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 owing to a combination of management fees, tax treatment and dividend timing. ETFdb notes that funds that use physical replication exhibit larger tracking errors than ones that use synthetic replication. Investors need to be aware of this difference when selecting ETFs with physical replication.
ETFdb’s head-to-head comparison tool compares ETFs along various criteria, such as performance, assets under management, trading volume and expenses.
7. Counterparty Risk
Counterparty risk generally comes into play when dealing with securities lending and synthetic replication, according to ETFdb. In the case of securities lending, the risk is seen when holdings are lent to another investor for a short period. This risk can be minimized by establishing collateral requirements.
With synthetic replication ETFs that track indices via swaps, risks can be mitigated by collateralizing the fund’s swap exposure. This leads to higher risk for which investors are compensated by being offered lower tracking error and lower fees compared with their physically backed peers.
Counterparty risk can also occur when dealing with exchange-traded notes, which are essentially unsecured debt notes issued by a bank. Examples are iPath S&P 500 VIX Short-Term Futures ETN (VXX) and VelocityShares Daily Inverse VIX Short-Term ETN (XIV). When trading ETNs, investors can come up losers in the event the bank goes bust, according to ETFdb — not necessarily a deterrent to investment in the notes, but a risk to be aware of.
8. Tax Risk
ETFs’ much-vaunted tax efficiency does not apply to all of them, so it is important for investors to study a fund’s tax treatment, especially if it is exposed to commodity and currency markets. These funds are usually taxed differently than others, according to ETFdb.
- Short-term tax rate: grantor trust, 39.6%; LP, 28%; ETN, 39.6%
- Long-term tax rate: grantor trust, 28%; LP, 28%; ETN, 20%
- Distributes a K-1 form for LPs
- Short-term tax rate: open-end fund, 39.6%; grantor trust, 39.6%; LP, 28%; ETN, 39.6%
- Long-term tax rate: open-end fund, 20%; grantor trust, 28%; LP, 28%; ETN, 20%
- Distributes a K-1 form for LPs
Although ETFs typically do in-kind transactions to avoid paying capital gains distributions, actively managed funds 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, and commodity and currency ETFs.
9. Closure Risk
Some 100 ETFs on average close each year, at which time managers liquidate the fund and pay out their shareholders. Managers incur capital gains, transaction expenses and in some cases legal expenses, which ultimately make their way down to the investor.
ETFdb says investors should sell an ETF as soon as the issuer announces it will close.
10. Hype Risk
ETFs are all the rage these days, with new funds popping up everywhere. Buzz is bound to happen, often feeding into herd mentality.
ETFdb says that although exuberance is to be expected in a bull market, investors should be wary of chasing the “next big thing,” and stick to their investment strategy and study each ETF’s methodology and documentation.
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