Do you know the ETF risk you face when you own 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 go a long way to improving your overall return.
ETFs are based on an index or benchmark. When there is a divergence in the return earned by the ETF from the index, you have a tracking error. In theory, tracking errors can be positive, meaning you will profit from the divergence or they can be negative, you receive less than the index would indicate. Usually, tracking error risk can reduce the performance of the ETF slightly.
The fees charged to run the ETF will negatively affect the return 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 check list.
Managers of funds 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 exactly the same stock at the exact same weights as the underlying index. Staying current with the index can raise trading costs, though it tends to reduce tracking errors after fees.
Other funds employ an optimization strategy, buying a subset of the underlying index’s stocks, believing they will provide similar performance to the full portfolio as a lower trading cost. The extent the managers of the ETF use optimization techniques influences the size of the tracking error. The goal of optimization is to help reduce trading costs, which will lower fees.
With so many ETFs trading, there are a number of funds that are traded thinly, creating one of the more important ETF risk. Their bid ask spread can be quite wide. Whenever a security is not widely traded, investors may find it difficult to sell their ETF should they want to do so. Without ready buyers, you may find you have to lower your price further than expected to complete a sale. The same can take place when you are buying. Without a widely traded market, investors can find there orders go unfilled unless they adjust the price well beyond the current bid-ask.
Shares purchased on a highly volatile day-say, during a news-driven 5 percent dip in an index on an otherwise flat trading day-can have a significant impact on long-term performance. This is especially true of an ETF that is not experiencing sufficient trading volume. Look for at least 100,000 average shares traded per day. More is better.
Narrowly Focused ETF
Narrow sector funds have a problem, because Securities and Exchange Commission (SEC) diversification requirements place restrictions on the construction of a portfolio. The basic ground rules for all mutual fund (including ETFs) are:
- No single security can be more than 25 percent of the portfolio; and
- Securities with more than a 5 percent share can't make up more than 50 percent of the fund.
For ETFs based on a narrowly focused index, these rules make it more difficult to match the underlying index.
Creating a portfolio of ETFs might cause you to overweight a stock or sub-sector unintentionally. One of the advantages of an ETF is you are able to get exposure to a broader spectrum of the market or a specific sector. However, each ETF is comprised of individual securities that could change you original intention giving you more exposure to a specific stock or sub-sector. Be sure to understand the underlying make-up of the index and the securities within the ETF to avoid encountering the risk of double coverage.
The Bottom Line
Knowing your ETF risk is part of your due diligence when evaluating an Exchange Traded Fund investment opportunity. While each of these risks might be considered a minor problem, they can add up to create sufficient risk to alter your final decision. Lower your ETF risk by knowing what you are buying.