What are the risks? ETFS?
Of course they are cheaper than community funds. Of course, they are more tax efficient than Community funds. Of course they are transparent, well structured and simply well designed.
But the risks? There are dozens of them. However, let’s discuss the top 4 for this article.
1) Market Risk
The greatest risk in ETFs is the market risk. The market is growing (yep!). They’re shrinking too (boo!). ETFs are just the downside of their underlying investments. So if you buy an S&P 500 ETF and the S&P 500 falls 50%, the cheapness, tax efficiency, or transparency of an ETF won’t help you any further.
2) The risk of not judging a book by its cover
The second biggest risk we face with ETFs is the risk of not judging a book by its cover. With more than 1,800 ETFs on the market today, investors have many choices to make within the market they choose. In recent years, the difference between the top performing “biotech” ETF and the worst “biotech” ETF has been more than 18 percent.
Why? One of these ETFs includes next generation genomics companies trying to cure cancer, while the other includes tooling companies serving the life science industry. Both biotech? Yes. But they mean different things to people.
ETF.com’s “Segment Reports” provide investors with a complete overview of all ETFs that are competing for investor attention in various areas of the market. Just use our Viewfinder You can then view all ETFs side by side.
3) Risk of termination
There are many ETFs that are very popular, but there are also many that do not receive love. Around 100 of these unloved ETFs are torn out of their misery every year.
An ETF that is discontinued is not the end of the world. The fund will be liquidated and the shareholders will be paid. It’s just not fun. Often times, during the liquidation process, the ETF realizes capital gains that are paid out to registered shareholders. In addition, there are transaction fees, inconsistent tracking, and a few other abuses. One fund company even had the courage to pass on the legal costs of closing the fund to the shareholders (It’s rare, but it happens).
In general, we recommend selling an ETF as soon as possible when it is announced that it is going to close. If you are concerned, ETF.com has its own resource, Fund Termination Risk, which assesses the chances of an ETF closing. Check the Efficiency tab for each ETF to verify this: if it says High, stay away from it.
4) The new best risk
The ETF marketing machine is a powerful force. Every week – sometimes every day – there’s the latest … the very best ETF … a fund that outperforms everyone else in the market with lower risk while singing the national anthem.
As Public Enemy warned: “Don’t believe the hype(Don’t believe the hype).
While there are plenty of great ETFs out there, be careful of anything that a free lunch promises to be. Study the underlying materials carefully, work to fully understand the underlying index strategy, and do not trust untested returns.
The rule of thumb is that the amount of money invested in an ETF should be inversely proportional to its attention. Which New ETF for Social Media / 3D Printing / Machine Learning? This is not suitable as the core of your portfolio.
In general, ETFs do what they say they do and do it well. However, to say that there are no risks is to ignore reality. Do your homework.