Top 8 Risks associated with ETFs
While you’ve seen how ETFs can be a good addition to your portfolio, there can be some risks associated with investing in ETFs too.
Understanding any risks associated with your investment beforehand is always beneficial for you.
Let’s walk through some risks associated with ETFs
1. Market risk
Often called systematic risk, this is the single most significant risk while investing in ETFs.
An ETF is a collection of its underlying securities. Thus, the movement of these securities in the stock market affects the ETF as well.
For instance, if an ETF is tracking the Sensex and it drops by 20%, nothing in the world can stop this ETF from also falling. No advantage of the ETF will harbor this fall but can cushion it, if not entirely prevent.
2. ‘See it before buying’ risk
This type of risk is the second most significant risk associated with investing in ETFs. An investor should be very vigilant when choosing an ETF.
Given the current scenario wherein more than 7600 ETFs are trading in the stock markets worldwide, studying carefully and looking at its underlying assets before investing becomes a paramount prerequisite.
Several ETFs can be tracking the same sector but may vary considerably by their underlying assets.
For instance, an ETF tracking the pharmaceutical industry should follow next-gen pharma companies having innovation in R&D, along with a promising future.
Such an ETF will have a higher return compared to an ETF tracking the pharma sector (but not tracking such high potential companies).
Hence, ‘judging a book by its cover’ risk becomes vital.
3. Counterparty risk
Counterparty risk is the probability that the counterparty in a transaction may not fulfill part of the deal and default on its obligations. An ETF can track the underlying index in two ways.
- It holds the underlying securities
- ETF swaps investor cash with a bank or financial institution for the index’s performance.
The former is a physical ETF, and the latter is a synthetic ETF.
Both investments have a certain degree of counterparty risk, but the probability is minimal and somewhat higher in the second.
However, we must keep in mind that ETFs are extensively collateralized and are safe.
4. Exotic-Exposure risk
As stated earlier, several types of ETF are doing rounds in the market, including some very complex specialized ETFs like inverse ETFs and leveraged ETFs.
Such ETFs use complex strategies to invest money, which may not always pan out the way one hopes. Hence doing due diligence before investing in such exotic ETFs is indispensable.
Similar to ice cream, moving beyond traditional, plain, and time-tested flavors increases the risk of being left with a sour taste.
5. Shutdown risk
Several ETFs are floating on global markets, but the investors love not all; hence some close down! About 100 ETFs close down every year, thus leaving their investors high and dry.
When an ETF is closed down, the investors get compensation in cash after liquidating the fund’s holdings. However, this isn’t an enjoyable experience in general.
Improper tracking of records on the part of the fund can lead to several grievances and, most importantly, mental agony for the investor.
6. Hot-new-thing risk
ETFs launched with such pomp trick investors into subscribing to such ETFs without doing their due diligence. This risk needs to be countered by the investor’s conscience.
One must thoroughly study the underlying assets and the tracking methodology without bias of the splendors advertising.
According to ETF.com, a rule of thumb is that the investment amount in an ETF should be inversely proportional to the press it gets.
7. Tax risk
ETFs can have different structures and strategies, resulting in differentiated tax liabilities.
Some ETFs may use an in-kind exchange mechanism and thus have lower capital gains tax liability than those that use complex derivatives to track the underlying index.
Therefore, this can hamper the investor’s profits and tax non-tax liabilities. Unless an investor is entirely aware of the fund’s work, they may be caught off-guard.
8. Trading risk
ETFs are listed on the stock markets and can be traded just like a regular stock; this comes with its own set of liquidity risks. An ETF might not be very liquid, thus casting a shadow over its trading ability; it’s the first advantage.
An ETF having a small spread between bid prices is how to tackle this illiquidity problem. Some ETFs open with pomp and with time lose their sheen; thus, the illiquidity problem could set in.
Investors must vary of such ostentatious display by the ETFs – often called a Crowded- Trade risk but is related to trade ability risk.
ETFs deliver what they promise to deliver; reading the fine print is what differentiates an investor from a good investor