Although by simulating an index, an ETF can reduce and eliminate non-systematic risk through the diversification offered by investing in all the shares of an index, the systemic risk remains. Investors are exposed to market risks if the index that reproduces moves downwards. Mutual funds predominate here, as their active management enables them to take opposite positions in a declining market by reducing losses or generating profits for investors. But even then there are some risks involved in investing in ETFs.
Getting into the trap – Risks of Investing in ETFs
Although in most cases ETFs faithfully compose the indicators or commodities that follow, there are cases where tracking errors occur. By tracking error, we mean the performance error generated between the ETF and the relevant index or commodity. The tracking error can be zero, negative, or even positive.
It depends on factors such as:
- Market volatility
- Passive or active management
- Changes in the composition of indices
- Interest rate
- Potential leverage of the ETF
- Its liquidity
- The management costs of an ETF
- Its retention time, and more
The market for ETFs is relatively new compared to that of mutual funds. This means that newer ones do not have enough data to properly evaluate each ETF separately. However, for older ETFs, a potential investor can collect data and evaluate returns, risk, and tracking errors for 20+ years. In recent years, new ones are constantly being created. On the other hand, funds remain more or less the same in number and thus investors have more information regarding their potential returns and their management costs.
Synthetic ETFs achieve the performance of the following indicators through swaps. Despite the fact that they have the advantage of reducing tracking error in this way compared to physical ETFs, they are exposed to the counterparty risk, the risk that the counterparty will not fulfill its contractual obligations and will not pay the amount due on time. If the institution with which the swap has been made goes bankrupt or is at a financial disadvantage, then the swap will not take place.
How to Reduce the Risk
To reduce the risks of investing in ETFs, the chosen ETF must enter into collateralized agreements that, however, incur some costs. Even physical ETFs, however, are exposed to this risk, as they tend to lend their shares to make higher returns. That means that there is always the risk of not getting on time. It is widely believed that equity lending poses the same level of risk for a physical ETF similarly to swaps on a synthetic ETF (Bioy and Rose, 2012). As the risk of the swap provider failing to pay the issuer, the agreed performance is real, but the possibility of large losses on the ETF is minimal due to collateral.
Investors who choose ETFs that invest in foreign equities should be aware that they are subject to foreign exchange risk. Also, they may lose money even if the underlying index or commodity in which they invested spikes. Still, an ETF can be traded at different times than the underlying index it reproduces. For example, Asian market ETFs are traded in the US stock market.
It has been observed that due to the time difference the volatility can have large fluctuations due to important news (news effect), even if the index that is reproduced is not in trading hours. ETF trading does not stop even if the market whose performance is reproduced remains closed. Investing in ETFs in developed markets faithfully follows investing in indices. However, has been observed that ETFs investing in emerging markets show greater tracking error while their liquidity is not so great. It is something that the potential investor should consider.
Finally, the widespread use of ETFs is likely to lead to increased volatility in markets in which the shares of the index are traded. This phenomenon is more advent in shares of highly capitalized companies. This happens because they are more involved in the reproduction of an index (Itzhak, 2014). Increased volatility mainly concerns the last minutes of stock trading. Some forms of ETFs, and more specifically leveraged ETFs, need to get redefined.
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