Although exchange-traded funds (ETFs) are advantageous for most investors, it is prudent for those who are interested to learn about some of the key underlying risks of ETFs. Understanding these risks can help investors avoid unnecessary losses and optimise their returns. In this article, we explain the fundamental risks of ETFs that every investor must know:
1. Market Risks
Singapore is known to be a safe country, but it does not mean that we leave our doors unlocked and cash out in the open. Similarly, the concept of safety in investing is also relative. Index ETFs are considered to be safer than many actively managed funds, but there are some ETFs with undulating price trends that put extreme rollercoasters to shame.
Even though the mainstays of ETFs are portfolios that attempt to mirror the exchange index, there are many ETFs that have underlying portfolios in exotic instruments and commodities.
Regardless, the value of ETFs will rise and fall according to market conditions. Variations exist even for ETFs that maintain exposure in the same sector because they don’t always hold the same stocks, and their performance differences can be significant. Investors should examine the returns volatility of the underlying assets of ETFs and avoid those that exceed your risk tolerance.
2. Composition Risks and Tracking Errors
Even for ETFs that track stock indices and other benchmarks, there is a non-trivial probability that the fund managers fail to do their jobs. As much as we would like to criticise them, there are many factors that contribute to tracking errors: fees, taxes, the timing of dividends, and changes in the composition of stocks in the indices, to name a few.
Fundamentally, the tracking of indices can be performed in two ways. First, a fund manager may wish to hold the same stocks with the same weightage as an index. This is known as physical replication and typically has larger tracking errors.
The second approach for a fund manager is to replicate the index using a combination of stocks and alternative instruments (such as swaps). This financial engineering approach is known as synthetic replication and typically has smaller tracking errors.
Choosing ETFs with low tracking errors are important for investors who want to accurately mirror the returns of indices/benchmarks.
3. Trading Costs and Liquidity Risks
Although ETFs are known to have the lowest cost structures, the cost is not zero. Commissions, sales charges, management expense ratio, creation and redemption fees, and taxes can vary widely across ETFs in different jurisdictions.
Another important cost component is bid-ask spreads. The experience is the same as when dealing with money changers – you sell at a lower rate than when you buy. Spreads are higher when an ETF is less popular and increases when large orders are fulfilled. Although variances in investment returns cannot be totally avoided, investors do have control over minimizing transaction costs to ensure higher returns.
Another common liquidity risk is known as the crowded trade risk. This happens when market participants hold large and similar positions within the trade, and there may be insufficient buying demand should they want to exit at once. Imagine an overcrowded restaurant during peak hours. If a fire suddenly breaks out (large unexpected market downturn), all the patrons will be rushing for the exits but not everyone will make it to safety.
It is imperative to be aware that this phenomenon can happen to any security on the exchange, and you should always be prepared to head for the exits first during times of uncertainty.
4. Price Deviations from Net Asset Value (NAV)
The combination of factors mentioned above affects the demand and supply conditions for ETFs. Hype and bullish sentiments push demand upwards, and fear pushes it downwards. As such, the price of ETFs can deviate from the actual value of the portfolio of underlying assets, and investors may end up paying much more for a hyped-up ETF compared to buying its underlying assets.
For ETFs invested in overseas stocks, news that breaks after-market hours (or during periods of suspension) can cause the ETFs’ prices to significantly deviate from that of the underlying overseas assets. Overreaction or underreaction to the news may cause investors to make losses when the real adjustments to the prices of the overseas assets do not fall in line.
5. Counterparty and Closure Risks
Typically, synthetic replication and securities lending activities in ETFs require another investor or financial institution to commit to the counter position. Counterparty risks materialize when these 3rd party entities are unable to fulfill their side of the bargain. Such risks can be mitigated through careful inspection of the ETFs’ methodologies and by avoiding exotic funds (such as ETFs outside of equities and fixed income).
According to multiple sources, approximately 100 ETFs close down every year. An ETF commences this proceeding by liquidating its portfolio and other assets and paying shareholders back in cash. However, the ETF may charge transaction and legal costs before disbursing the net cash to shareholders.
Thus, investors should be careful about selecting ETFs by making sure that they are well-backed by reputable institutions, and sell out their position as soon as the ETF announces its intention to close.
Dr. Jack Hong is the co-founder of Research Room Pte. Ltd., a management consulting and advanced analytics company that delivers complex prediction and decision-making capabilities for commercial, government, and not-for-profit organizations. Dr. Hong has extensive research and commercial experience in applying advanced empirical science to drive business, financial and policy value chains. He is concurrently an adjunct faculty with the Singapore Management University (SMU).