The Winklevoss Bitcoin ETF is Risky. Other ETFs Can be Risky Too.
Cameron and Tyler Winklevoss have filed a registration statement with the SEC to create new Bitcoin exchange-traded fund. The Winklevoss twins fought a lengthy legal battle with Mark Zuckerberg, claiming he stole the idea for Facebook from them when they were undergraduates at Harvard University. Their Bitcoin ETF offers investors, as stated in an SEC filing, an “opportunity to realize a riskless profit….”
Most seasoned investors will likely avoid this speculative ETF. However, 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. But investors are switching to ETF’s without fully understanding what they are buying.
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.
While ETF’s can be useful in constructing a portfolio to meet investors’ goals, misused 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 21% 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 where volume is high and market velocity rapid, ETFs have decoupled from their underlying net asset value. Also, many bond ETFs seem to trade at a premium or discount to net asset value.
UPDATE: There is evidence that this actually happened to some BlackRock funds in July 2013. Read more here>>
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.
We believe investors are better served by following our three-part value investing strategy:
- Appraise the intrinsic value of each company over a business cycle;
- Seek long-term growth of capital by investing in companies that we perceive to be mispriced;
- Utilize a margin of safety to promote return of capital…not just return on capital.