Exchange Traded Funds Expose Investors to Unexpected Risks

In June’s market turmoil, some fixed-income Exchange Traded Funds “decoupled” from their underlying net asset value.

Over the past decade, investors have moved billions of dollars out of mutual funds and into ETF’s. Why are ETF’s so popular? Low management fees are the main reason. ETF fees are in the 0.5% range, compared with 2% to 3% for many large Canadian mutual funds. However, in many cases, investors are switching to ETF’s without fully understanding what they are buying.

ETF, Exchange Traded Funds

Exchange Traded Funds Expose Investors to Unexpected Risks

Exchange traded funds (ETF’s) are investment funds that trade on stock exchanges, much like stocks. ETF’s holds assets such as stocks, commodities, or bonds.  Many ETF’s track an index, such as the S&P/TSX Composite here in Canada or the S&P 500 in the US. Others track market sub-sectors, such as the S&P/TSX Capped Energy index.

In June of this year, markets were roiled by concerns about rising interest rates in the US. Fed Chairman Ben Bernanke’s comments about ‘tapering’ or reducing QE, lead to investors dump both bonds and equities. During that time, the huge volume of sell orders caused SPDR Nuveen S&P High Yield Municipal Bond ETF to “decoupled” from its underlying net asset value. This is referred to as ‘liquidity risk,’ and means that investors selling these funds received less that the market value of the underlying assets.

Attempting to make a virtue out of this failure, Mark Wiedman, global head of iShares, wrote an open letter to investors claiming that the “ETF price can become the true price for that market.”

While ETF’s can be useful in constructing a portfolio to meet investors’ goals, if misused or misunderstood, they can expose investors to a number of risks:

Market Risk Perhaps the most significant risk associated with ETFs is market risk. If you purchase an ETF that tracks the S&P/TSX Composite index for example, you have just put half of your money in the resource sector.  You will experience significant volatility as the index responds to changes in commodity prices.

Concentration Risk –The degree of diversification in any particular ETF varies significantly and the underlying portfolio should be closely examined to see what level of diversification a fund may offer. For example, the iShares S&P/TSX Capped Information Technology Index Fund holds only 7 stocks, including a 20% exposure to RIM.

Sampling Risk While some index ETF’s invest 100% of their assets proportionately in the securities underlying an index—referred to as “replication”–other index ETFs use “representative sampling”, investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as futures, option and swap contracts. For index ETFs that invest in indices with thousands of underlying securities, some index ETFs employ “aggressive sampling” and invest in only a tiny percentage of the underlying securities.

Liquidity Risk All ETFs are purchased on an exchange with a bid and offer. In some cases, the number of shares trading in any given day may not easily support a sale or purchase at an efficient price relative to the underlying net asset value. In other cases–as some ETF investors experienced in June–where volume is high and market velocity rapid, ETFs have decoupled from their underlying net asset value.

Leveraged ETFs – The use of leverage to amplify the rate of change for an investor has unique risks. Leveraged ETFs use swaps futures, and other derivatives to return two or three times the underlying index (or two or three times opposite that index’s movements) on a daily basis. This can expose investors to extreme volatility.

Interest Rate Risk –As interest rates rise and fall over time, these changes have a direct effect on the value of ETFs that are investing in bonds. As interest rates rise, the value of an ETF invested in bonds should be expected to fall. In a declining interest rate environment, the value of a bond ETF investment should rise. Longer term bonds are more sensitive to changes in future inflation expectations than are short term bonds.

Foreign Investment Risk – Many ETFs are organized to hold stocks from outside of Canada or the US. Investing in a basket of international stocks poses addition risks to shareholders including currency risk, liquidity risk, geopolitical considerations, less well established public markets and less stringent accounting methods.

Investors are better owning equities or fixed-income investments directly, rather than purchasing them indirectly through opaque vehicles, such as ETFs, that may expose them to other risks. Discount brokerage accounts allow small investors to purchase securities and achieve diversification at low cost. Independent investment publications can help them select appropriate equities and fixed-income issues. Portfolio managers can help investors with larger portfolios achieve appropriate diversification and risk management.

Update: the Dividend Ninja, a Vancouver based writer, makes a compelling argument for the benefits of dividend stocks over ETFs.