ETF Risks & How To Avoid Them

December 30, 2020

[This article appears in our January 2021 issue of ETF Report.]

 

Investing has risk. Period. But each investment type has risks inherent to the vehicle, and exchange-traded funds are no different.
In ETFs, there are perceived risks and actual risks, and this year cleared up worries about at least one perceived risk: that in times of market stress, ETFs would be a disaster for investors.

Critics particularly flagged bond ETFs as being too new, that certain strategies received too many inflows and that sellers would be stuck.

“That was never true,” said Todd Rosenbluth, director of ETF research at CFRA. “We have proof that it wasn’t true during March 2020. Investors turned to fixed income ETFs as a way to access the bond market because there was somebody on the other side of that trade.”

Elisabeth Kashner, director of ETF research at FactSet, called those worries about bond ETF
“a manufactured concern.”

She says that when people specifically asked her about investors not being able to sell bond ETFs, “I would wind up just sort of staring them down and saying, ‘So you’re telling me that every bond in the entire portfolio is going to be zero bid; that there will be not one buyer?”

Key Investor Lesson
What actually happened when liquidity dried up during the March 2020 bond market break was that panicked sellers sold their ETFs at a price that wasn’t necessarily net asset value. That’s the lesson investors should take away: Don’t panic-sell because prices are stale and discounts are likely.

Kashner believes that episode showcased one of the “finest features” of ETFs: that traders—not the current shareholders—bear the transaction costs, unlike in mutual funds.

“Is there not some appropriateness to the panic seller paying a price for demanding liquidity in an uncertain market?” she noted. “You know what doesn’t happen in that instance? The rest of the ETF holders don’t get fleeced, because their portfolio manager is not having to sell the most liquid bond to meet redemptions, which, in a market panic, transact at artificially high NAVs.”

Bond ETFs withstood a severe market test in March 2020, but there are other risks for investors to worry about. Here are a few of the bigger ones and how to avoid them.

Don’t Judge A Book By Its Cover
Kashner suggests that active risk is investors’ biggest issue. This is the economic risk investors take, such as if an investor buys a small cap ETF versus the total market, or buys a single-country ETF versus a region. Even in segments, funds with similar names have significantly different  returns (see Figure 1).

 

Pot_ETFs_compare

(For a larger view, click on the image above)

 

“The poster child for that is biotech, but I’ve seen it in ‘boring’ stuff like utility ETFs,” she said.

Investors can mitigate some of this by knowing what they own and why, but Kashner also mentions that what investors don’t know is whether the active bet will pay off. That’s why narrower ETFs come with other risks and rewards.

They may be different than the overall market, she says: “That difference opens the door to opportunity, but that door can also slam you in the rear. That’s the biggest risk, and it’s mitigated by breadth and diversification.”

Related to active risk are the costs of niche markets with low secondary-market turnover, meaning a small amount of liquidity available at the exchange. Fund expenses can be a good predictor of long-term holding costs, and the fund may do things to lower those costs internally, such has having an active securities lending program, or a strong foreign dividend recapture. But there are other costs to consider when ETFs tap into illiquid markets.

Will Rhind, CEO of GraniteShares, reminds investors that the ETF itself isn’t illiquid, but that there’s less demand on the secondary market for those shares at any given time. ETFs have market makers who are supposed to post visible bid/offer spreads, according to exchange rules.

“You just have to exercise more caution when you have a fund that is thinly traded,” he said, because if the market order is bigger than the quote size, investors may get their trades done at a wider spread, so execution costs will be higher.

Rhind notes the biggest misconception about ETFs is forgetting that these vehicles are wrappers providing exposure to an underlying asset class, and asset classes are different. He explains that investors need to understand the market they’re getting exposure to through an ETF to understand the individual risks.

For example, a hallmark of ETFs is their tax efficiency during rebalancing and selling. However, differences in what an ETF holds and how it may be structured means that investors may also pay different taxes, Rhind explains. An ETF that invests in equities will have a different tax treatment than one that invests in futures, a partnership or physical precious metals, and investors should be aware of how the Internal Revenue Service categorizes those investments.

Leveraged & Inverse ETFs
Andrew Mies, chief investment officer of 6 Meridian, says that most of the ETF “horror stories” are about leveraged ETFs that went against the investor. CFRA’s Rosenbluth explains that these types of ETFs can lure unsuspecting investors because their returns are often at the top—or bottom—of performance charts because of that leverage.

Inverse ETFs, which are designed to ride negative market momentum, are anotLevher risky vehicle. Rosenbluth suggests that investors who want to use these types of ETFs have short-term tactical—not strategic—reasons because of their compounding effect: “The longer you’re in these products, the more risk there can be. An ETF that goes up 5% and then down 5% and back up 5% is not breaking even.”

Closure Risks & Defaults
ETFs defaults are extremely rare, and Kashner says there have been four defaults since the ETF concept debuted in 1993. And that involved exchange-traded notes that were backed by Lehman Brothers and Bear Stearns, which defaulted during the 2008 credit crisis. Actual ETFs can’t default, because they’re backed by actual assets—usually securities—rather than by the resources of an individual bank.

Closure risk is a far more plausible concern with a genuine ETF and can happen for different reasons, usually because of low asset levels. Kashner says an investor’s principal is not at risk when a fund closes, but they could have a tax event if the fund closes at a higher price than where the investor bought it, or a capital loss if the price is lower.

She says FactSet rates ETFs on a low, medium and high risk for closing, using metrics such as net inflows, regulatory risk and if two fund houses merge.

When An ETF Isn’t An ETF
Many people casually assign the term “ETF” to ETNs, but they aren’t the same. Rhind explains that these are debt securities issued by a bank and they have a different regulatory structure. The investor holds that bank’s debt as an unsecured creditor.

Only the bank can initiate the creation/redemption process for their ETNs, Rhind notes, so they don’t have ETFs’ independent authorized participation network and arbitrage mechanism. Banks can often call them at any time to close them, especially with newer ETNs. When that happens, investors are put in a “close-only mode,” limiting tradability since they can only be sold.

Because of the ETN’s structure, the only way to avoid this risk is not to own one.

2020 saw a rash of ETN closures, and Kashner observes that three-quarters of all ETNs are no longer trading on exchanges. Because of that, FactSet’s fund closure metric has no ETNs rated as low risk. Banks have closed even big, billion-dollar ETNs, she notes.

“Don’t tell me it’s low risk,” she said.

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