Looking under the hood of any fund you own can prevent a lot of surprises.
Exchange-traded funds are often heralded for three main reasons; namely, their low cost structure; their portfolio transparency; and their tax efficiency—all things that have allowed the ETF market to grow roughly at a 25-percent-a-year pace, much to the detriment of the mutual fund industry. But there are plenty of risks in ETFs that often go overlooked.
Here we list what we consider to be four of the biggest risks associated with ETFs:
1. Market risk is always there.
Investing is a risky business, whether you do it through ETFs or any other vehicle.
Yes, ETFs are great, easy-to-use tools, but for the most part, they don’t protect you from market risk. The majority of ETFs are passive instruments designed to replicate market returns. It may sound obvious, but when the S&P 500 goes up, like it did in 2013, ETFs that track those stocks will also go up and capture hefty returns. The reverse is also true.
That said, ETFs are sophisticated enough to serve up varying levels of beta, or market risk, even if they can’t completely protect you from market action.
A good example here is a pair of funds that tap into the S&P 500, but that offer varying levels of beta.
The PowerShares S&P 500 High Beta Portfolio (SPHB | A-43) tracks a beta-weighted index of the 100 highest-beta stocks in the S&P 500. The fund is designed to magnify market gains, and appeals to investors who are very bullish on U.S. stocks, according to ETF.com Analytics. Think of it this way: If market risk—or beta—is 1.0, SPHB currently delivers a beta of nearly 1.4.
The PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-46), meanwhile, tracks a volatility-weighted index of the 100 least volatile stocks in the S&P 500. The fund is popular with some of the most risk-averse investors, serving up beta of 0.83.
Clearly, ETFs can help you manage your exposure to market risk through different strategies, but at the end of the day, in a crashing market, your ETF will still bleed, unless of course you own an inverse strategy. But that’s another discussion.