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