Do you know the ETF risk you face when owning exchange traded funds? The popularity of exchange traded funds has grown exponentially. Like any investment, there are a number of risks associated with these ETFs. Knowing the details of your ETF can greatly improve your overall return.
ETFs are based on an index or a benchmark. When there is a divergence in the return earned by the ETF versus the index, you have a tracking error. In theory, tracking errors can be positive meaning you will profit from the discrepancy or they can be negative you receive less than the index indicates. Usually, the risk of tracking error can slightly reduce the performance of the ETF.
The fees charged to manage the ETF will negatively affect the performance of the ETF relative to the index. While most ETFs have low expense ratios, be sure to add this item to your ETF risk assessment checklist.
Fund managers face several challenges including how to manage changes in the underlying index and what method to use to match the index. Some funds use a replication strategy, buying the exact same stock at the same weights as the underlying index. Keeping up to date with the index can increase trading costs, although it tends to reduce tracking errors after fees.
Other funds use an optimization strategy, buying a subset of the stocks in the underlying index, believing that they will provide similar performance to the entire portfolio. at a lower trading cost. The extent to which ETF managers use optimization techniques influences the extent of tracking error. The goal of optimization is to help lower trading costs, which will lower fees.
With so much ETF trading, there are a number of funds that are traded lightly, which creates one of the biggest risks in ETFs. Their bid ask spread can be quite wide. Whenever a security is not widely traded, investors may have difficulty selling their ETFs if they wish. Without ready buyers, you may have to lower your price more than you expected to make a sale. The same can happen when you buy. Without a widely traded market, investors can find unfulfilled orders there unless they adjust the price well above the current bid-ask price.
Stocks bought on a very volatile day – for example, when a news index fell 5% on a news item on an otherwise trading day plate – can have a significant impact on long-term performance. This is especially true for an ETF that does not experience sufficient trading volume. Look for at least 100,000 average stocks traded per day. More is better.
Narrowly focused ETFs
Restricted sector funds have a problem, as the diversification requirements of the Securities and Exchange Commission (SEC) place restrictions on building a portfolio. The basic rules of all mutual funds (including ETFs) are as follows:
o No security can represent more than 25% of the portfolio; and
o Securities with more than 5% share cannot constitute more than 50% of the fund.
For ETFs based on a tightly targeted index, these rules make it more difficult to match the underlying index.
Building an ETF portfolio can lead you to unintentionally overweight a stock or sub-sector. One of the advantages of an ETF is that you are able to gain exposure to a wider spectrum of the market or to a specific sector. However, each ETF is made up of individual stocks that might change your original intent by giving you more exposure to a specific stock or sub-sector. Make sure you understand the underlying composition of the index and the securities within the ETF to avoid running the risk of double hedging.
The bottom line
Knowing your ETF risk is part of your due diligence when evaluating an investment opportunity in an exchange traded fund. While each of these risks could be considered a minor issue, they can add up to create enough risk to change your final decision. Reduce your ETF risk by knowing what you are buying.