Investors who choose to invest in foreign equity ETFs should be aware that they are under exchange risk. They may lose money even if the underlying index or commodity in which they have invested is moving upwards. Still, it is possible for an ETF to be traded at different times than the underlying index it reproduces. For example, Asian market ETFs are traded on the US stock market. It has been observed that due to the time difference the volatility can have large fluctuations due to important changes. The main reason is the news effect, even in the case that the index being reproduced is not in trading hours. That is why all investors should know the different elements that will affect the changes in ETF prices. In this article, we will discuss the pros and cons of Investing in ETFs.
Forming of last-minute call situations…
Although main ETFs, which originated from already developed markets, faithfully copy the indicators and it has been observed that investing in emerging markets shows higher tracking error while their liquidity is not so great, something it is crucial for the potential investor to take into account. The widespread use of ETFs is likely to lead to increased volatility in the markets. This phenomenon is greater in shares of highly capitalized companies. This mainly happens due to the fact that they are involved in the reproduction of an index. Increased volatility mainly concerns the few last minutes of stock trading, because some forms of ETFs, and more specifically leveraged trading, have to be redefined at the end of the day.
These transactions are known in advance by market participants, as the composition and objectives of ETFs are clearly defined. As a result, institutional investors take the same positions shortly before and liquidate their positions after a while. They lock in profits by exploiting the increased volatility at the end of the session (Bai et al, 2012). As those investments will increase, they will affect markets even more. It has been observed empirically that the higher the beta of a stock, the more likely it is to be affected by investments in main ETF portfolios consisting of this stock. Also, the higher the weighting of a stock in an index (and therefore in an ETF that reproduces that index), the more it is affected by fluctuations in the trading volume.
From the above characteristics of ETFs, we can briefly summarize their advantages and disadvantages.
The Pros and Cons of Investing in ETFs: All you need to know
Advantages
- Reproduction of the course of an extensive range of underlying instruments, such as indices, commodities (precious metals, agricultural products, natural resources), bonds, exchange rates, or groups of shares.
- They are traded in real-time on the stock exchanges, unlike mutual funds which can be bought or sold only once at the end of the day.
- Main ETFs do not have a predetermined expiration date and a margin account is required to invest in them.
- They have significantly lower management costs compared to mutual funds.
- Differentiation of non-systematic risk is achieved without the need for a small investor to buy a large number of securities and pay large sums in commissions.
- ETFs are very transparent, as they have to disclose how they will implement the declared investment policy.
- They are fully liquid due to the presence of a specialist trader, the sale of their shares can be made at any time during the trading session.
- For mid-range (moneywise) investors are given the opportunity to invest in emerging markets or commodities, which until recently was very difficult.
- Investors can sort main ETFs just as they sort stocks while building an ETF Portfolio.
- Due to their structure, they show significant tax benefits compared to other financial products.
Disadvantages
- Investing in ETFs cannot eliminate the systemic risk that exists in the markets.
- Depending on the type of ETF there may be a significant tracking error.
- For newer products, there is not enough historical data for investors to evaluate their profitability over time.
- The practice of lending shares and making swaps to reproduce an index entails counterparty risk.
- ETFs investing in foreign equities are subject to foreign exchange risk.
- There are significant concerns that the widespread use of ETF portfolios increases market volatility.
Want to learn more? Check out the video of MoneyGuy
