ETF risk

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 in improving its overall performance.

tracking error
ETFs are based on an index or benchmark. When there is a divergence in the performance achieved by the ETF from the index, it has a tracking error. In theory, the tracking errors can be positive, meaning you will benefit from the divergence, or they can be negative, meaning you receive less than the index would indicate. In general, the risk of tracking error can slightly reduce the performance of the ETF.

Fee
Fees charged to run the ETF will negatively affect the performance of the ETF relative to the index. While most ETFs have low expense ratios, be sure to add this item to your ETF underwriting checklist.

Index matching
Fund managers face a number of 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 shares at exactly the same weights as the underlying index. Keeping up with the index can increase trading costs, although it does tend to reduce tracking errors after fees.

Other funds employ an optimization strategy, buying a subset of the underlying index stocks, believing they will provide a return similar to that of the entire portfolio as a lower cost of trading. The extent to which the ETF managers use optimization techniques influences the magnitude of the tracking error. The goal of optimization is to help reduce business costs, which will lower fees.

Liquidity
With so many ETFs traded, there are a number of funds that are under-traded, creating one of the most significant ETF risks. Your bid and ask spread can be quite wide. When a security is not widely traded, investors may find it difficult to sell their ETF if they choose to. Without ready buyers, you may have to lower your price more than expected to complete a sale. The same can happen when you are shopping. Without a widely traded market, investors may find that orders are not filled unless they adjust the price well beyond the current bid.

Stocks bought on a highly volatile day, for example during a news-driven 5 percent decline in an index on a 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.

Narrow Focus ETF
Restricted sector funds have a problem, because the Securities and Exchange Commission’s (SEC) diversification requirements place restrictions on building a portfolio. The basic rules for all mutual funds (including ETFs) are:

o No single security can be more than 25 percent of the portfolio; Y
o Securities with more than 5 percent participation cannot represent more than 50 percent of the fund.

For ETFs based on a narrow focus index, these rules make it more difficult to match the underlying index.

Double coverage
Building an ETF portfolio can cause you to inadvertently overweight a stock or sub-sector. One of the advantages of an ETF is that it can be exposed to a broader spectrum of the market or to a specific sector. However, each ETF is made up of individual securities that could change their original intent and give you more exposure to a specific stock or sub-sector. Make sure you understand the underlying composition of the index and the securities within the ETF to avoid the risk of double hedging.

The bottom line
Knowing the risk of your ETF is part of your due diligence when evaluating an investment opportunity in an exchange-traded fund. While each of these risks can be considered a minor issue, they can add up to create enough risk to upset your final decision. Reduce your ETF risk by knowing what you’re buying.