4 Of The Biggest Risks Related To ETFs

May 09, 2014

3. Labels can be misleading. Not all funds in any given segment are created equal.

ETFs are essentially baskets of various securities that trade under a single ticker. Knowing what you own inside that wrapper makes all the difference.

Consider for a moment the biotech ETF segment. There are four competing funds that focus exclusively on the U.S. biotech segment, excluding leverage and inverse strategies.

In the past 12 months, the best-performing ETF in that group saw total returns of more than 36 percent, while the worst-performing delivered only 18 percent in total returns. That’s an 18-percentage-point divergence between two competing biotech ETFs that’s due primarily to the different basket of securities they each own.

The PowerShares Dynamic Biotech & Genome ETF (PBE | A-31) led in the past year, with gains of 36.4 percent, while the competing SPDR S&P Biotech ETF (XBI | A-46) trailed, with total returns of only 18.7 percent in the same period.

Meanwhile, the iShares Nasdaq Biotechnology ETF (IBB | A-44)—the largest in the segment by a huge margin, with $4.7 billion in total assets—and the First Trust NYSE Arca Biotechnology ETF (FBT | B-33) were somewhere in the middle.

Go beyond the label—and the asset figures—to pick the ETF that best represents your view on a segment.

FBT_IBB_PBE_XBI_One-Yr-Perf

Chart courtesy of StockCharts.com

4. Many ETFs face high risk of closure, which can lead to expenses you might not be counting on.

Every year, we see new ETFs come to market, and a slew of them close because they fail to attract enough assets. By our estimates, about a fifth of all ETFs in the market today face a significant risk of closure.

When an ETF is shuttered, shareholders are paid in cash for the stocks they owned, so there’s not necessarily a loss, but you could be hit with a tax payment associated with the closure, and other transaction costs, that you weren’t expecting. It can be a hassle.

At ETF.com, we have a proprietary measure of fund closure risk that evaluates the chances an ETF will close. You can see that in the Efficiency tab on any ETF at www.etf.com/ticker.

Our recommendation: Avoid ETFs that face high closure risk, and if a fund you own announces it will be liquidating soon, get out of that position as quickly as you can.

 

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