ETFs have become one of the most popular investment vehicles in recent years, with over $2.5 trillion in assets under management as of July 2017.1 Investors have flocked to ETFs due to their low fees, tax efficiency and ability to track indexes closely. While there are many benefits to investing in ETFs, they are not without risk. This article will explore the most significant risks associated with ETF investing.
The biggest risks associated with ETFs
Manipulation
ETFs are susceptible to manipulation, increasing volatility and leading to losses for investors. In some cases, traders may manipulate prices by spreading false information or engaging in abusive trading practises.
Counterparty risk
ETFs rely on counterparties to provide liquidity and fulfil redemption requests. If the counterparty fails, the ETF may be forced to liquidate its assets at a loss, negatively impacting investors.
Leverage risk
ETFs often use leverage, which can amplify losses in times of market stress. For example, if an ETF shorts security and
the price increases, it may have to cover its short position at a loss if it cannot find shares.
Management risk
Although this sounds like an internal risk, managers can influence an ETF performance in several ways. Managers are responsible for ensuring the fund’s investments follow the index and meet transparency requirements. If managers change strategy or make poor investment decisions, investors may be negatively impacted by companies no longer represented in the fund or holdings purchased at inflated prices. Finally, managers could also decide to close holdings outside of their control which would force liquidation of assets leading to investor losses.
Liquidity risk
ETFs trade on exchanges throughout market hours, but prices do not always indicate an ETF’s underlying value. When investors want to sell their ETF shares, they may not find a buyer at the price they are willing to pay or vice versa. It’s known as liquidity risk and can lead to significant losses if the market moves against an investor.
Credit risk
ETFs may hold bonds and other debt securities, and if the issuer of those securities defaults, the ETF could suffer losses. For example, in 2008, during the financial crisis, several bond ETFs experienced significant losses due to credit downgrades and defaults by corporate issuers.
Structural risk
ETFs can be structured in different ways, impacting how they are taxed and how they distribute returns to investors. Certain ETFs may be exposed to additional structural risks which can harm investors’ returns, including the following: Mutual fund conversion, commodity pools and ETNs
Risk management risk
ETFs typically attempt to track an index as closely as possible, either by holding all of the securities in that index or by weighting their holdings according to that index’s rules. It means they are exposed to market risks inherent in those indexes, such as volatility and tracking error. However, ETF managers must also manage this risk and ensure their strategies meet investor expectations and follow any restrictions imposed by product providers and regulators. Failure on the manager’s part could lead to undesirable consequences for investors, such as losing dividends or a deteriorating net asset value.
Derivative risk
ETFs may use derivatives such as futures, swaps and options to track an index or gain additional exposure to specific markets. In some cases, this can increase returns, but it also increases the risk of loss due to the possibility of counterparty insolvency or derivative default.
Developers have been addressing these risks for years and mitigating them with products that allow investors to invest in ETFs without taking all the risks associated with them according to their preferences. These include: synthetic ETFs which mimic physical ETFs by purchasing assets, whereas physical ETFs have a third party custodian hold those assets for them market-linked CDs known as ETCs that provide a return linked to the performance of underlying ETF share classes that offer different levels of liquidity and tracking error.