Etfs: Risks, Rewards, And What You Need To Know

Exchange-traded funds (ETFs) are a popular investment tool due to their competitive fees, tax efficiency, transparency, and ease of use. However, like any investment, it's important to be aware of the potential risks involved. Here are some key risks to consider when investing in ETFs:

- Underlying asset risk: ETF investors are exposed to risks associated with the underlying basket of investments. For example, a bond ETF is exposed to credit, default, and interest rate risks.

- Market risk: The underlying assets of an ETF may fluctuate in value. An ETF tracking a specific industry or sector is likely to be more volatile than one tracking a broad market index.

- Liquidity risk: Low liquidity in an ETF can lead to higher trading costs and difficulty in buying or selling. The liquidity of an ETF is determined by the liquidity of its underlying securities.

- Tracking error: ETFs that track an index may not always deliver the same returns as the index due to factors such as fees and trading costs.

- Pricing differences: The market price of an ETF may not always reflect the exact value of its underlying assets, exposing investors to market forces when trading.

- Sector concentration: ETFs may appear diversified but can have a focus on certain sectors, significantly impacting their performance.

- Single-stock concentration: Some ETFs may have outsized positions in particular stocks, which can have an outsized impact on their performance.

- Tax risk: Not all ETFs are tax-efficient. Actively managed ETFs may incur capital gains, which need to be distributed to fund holders, and international ETFs may face taxation issues.

- Counterparty risk: While ETFs are generally safe from counterparty risk, it is a concern with exchange-traded notes (ETNs), which are simply unsecured debt notes backed by a bank.

- Exotic-exposure risk: Complex ETF strategies, such as those involving commodities or currencies, may not perform as expected and can have unexpected tax implications.

Market risk

ETFs are less risky than stocks because they eliminate specific risks. ETFs are diversified investments, allowing investors to invest in hundreds or thousands of companies at once. This diversification reduces the impact of a single company's poor performance on the overall investment portfolio.

However, ETFs are still exposed to systemic risk, which affects the entire market and cannot be mitigated through diversification. Systemic risk arises from factors such as major economic events. Investors are rewarded for taking on systemic risk through higher returns compared to safer investments.

The level of market risk associated with an ETF can be assessed through its risk rating, which is included in the ETF's Key Investor Document (KID). The risk rating is a number between 1 and 7, with 1 being the lowest risk and 7 the highest.

While market risk cannot be eliminated, investors can control their exposure to it. By building a portfolio of different ETFs with varying risk characteristics, investors can tailor the risk and return to match their financial goals and risk tolerance.

• Currency risk: Investing in ETFs that track foreign markets exposes investors to currency risk, but this can provide additional diversification for long-term investments.
• Counterparty risk: Some ETFs, especially synthetic ETFs, rely on financial derivatives, and there is a risk that the counterparty may default.
• Sector risk: ETFs that focus on specific sectors may face larger declines if that sector underperforms. This risk can be mitigated by diversifying across multiple sectors.
• Tracking error: This refers to the discrepancy between an ETF's performance and the performance of its underlying index.
• Leverage: Leveraged ETFs aim to amplify returns but are riskier than traditional ETFs as they can magnify losses.
• Liquidity risk: Some niche or specialised ETFs may have lower trading volumes, resulting in wider bid-ask spreads and price volatility.

Tracking error

The tracking error of an index fund is usually small, perhaps only a few tenths of one percent. However, various factors can sometimes cause a gap of several percentage points between the index fund and its target index.

For example, SEC diversification rules require that ETFs do not hold more than 25% of their portfolios in any one stock. This rule can create a problem for specialized funds seeking to replicate the returns of particular industries or sectors, as truly replicating some industry indexes may require holding more than a quarter of the fund in certain stocks. In such cases, the fund cannot legally replicate the actual index in full, so a tracking error is very likely to occur.

Fund management and trading fees are often the largest contributors to tracking error. Even if a fund tracks the index perfectly, it will still underperform the index by the amount of the fees deducted from the fund's returns. Similarly, the more a fund trades securities, the more trading fees it will accumulate, reducing returns.

Liquidity risk

• Secondary market liquidity: This refers to the trading of ETF shares on exchanges, as reflected in the quoted trading volume and bid/ask spreads.
• Primary market liquidity: This is the ability of authorised participants (APs) to create and redeem large blocks of ETF shares in response to market supply and demand.
• Liquidity of the underlying asset class: The liquidity of an ETF is also impacted by how liquid the securities are that the ETF invests in (e.g. US large-cap stocks are more liquid than emerging market bonds).

While ETFs generally have sufficient liquidity, some niche or specialised ETFs may have lower trading volumes, which can result in wider bid-ask spreads and price volatility. This can make it difficult for investors to buy or sell the ETF without moving the price.

To mitigate liquidity risk, investors should research the trading volume and market movements of an ETF before investing. It is also important to understand the underlying securities that the ETF invests in, as their liquidity will impact the overall liquidity of the ETF.

In addition, investors should be aware that during periods of high market volatility, the bid-ask spread for an ETF may widen, making it more difficult to buy or sell the ETF at a desirable price. This can result in increased trading costs and reduced investment returns.

Overall, while liquidity risk is a concern for ETFs, it can be managed by conducting thorough due diligence and understanding the underlying assets and market conditions.

Currency risk

However, it is important to note that currency risk can also work in your favour. If the foreign currency appreciates against your home currency, your investment will be worth more when converted back, resulting in higher returns. Additionally, if the foreign currency strengthens, the companies in which your ETF invests may benefit from improved financial performance, leading to potential gains in the value of your investment.

To manage currency risk, investors can consider the following strategies:

• Diversification: Spreading your investments across multiple countries and currencies can help to reduce the impact of currency fluctuations. By investing in ETFs that hold assets in various currencies, you can lower the risk of significant losses due to changes in any single exchange rate.
• Currency hedging: Some ETFs offer built-in currency hedging, which aims to minimise the impact of exchange rate fluctuations on your investment. These ETFs use financial derivatives, such as forward contracts or currency swaps, to protect against currency risk.
• Active currency management: Investors can also take a more active approach by monitoring exchange rate movements and adjusting their ETF holdings accordingly. For example, if you anticipate a particular currency will depreciate, you could reduce your exposure to that currency by investing in ETFs that hold assets in other currencies.

In conclusion, while currency risk is a consideration when investing in ETFs that track foreign markets, it is a risk that can be managed through careful planning and diversification. By understanding the potential impact of currency fluctuations, investors can make more informed decisions about their ETF investments.

Counterparty risk

ETFs that use derivatives such as futures or options introduce counterparty risk. If the counterparty defaults, it can hurt the ETF and its investors. While ETFs are generally safe from counterparty risk, it is a concern with Exchange-Traded Notes (ETNs). ETNs are unsecured debt instruments backed by a bank, and if the issuing bank defaults or goes bankrupt, investors may face losses.

Additionally, some brokers lend out ETFs to earn extra revenue, creating a risk that the borrower may not be able to repay the ETF. This practice can result in counterparty risk, and investors should be aware of their broker's policies regarding securities lending.

Frequently asked questions