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.
2. Beware of exotic ETFs—anything that’s not a “plain vanilla” fund.
ETFs have come a long way from the launch of the SPDR S&P 500 ETF (SPY | A-97) 21 years ago, to an industry that now includes nearly 1,600 different funds in the U.S. alone, tapping into just about every corner of the market.
Today an investor of any size can own not only stocks and bonds, but commodities, currencies, single countries, emerging market debt—and anything in between—in an ETF wrapper.
Herein is the risk: The more you move away from plain-vanilla funds, the more you could run into an exposure so exotic it doesn’t really deliver what you were looking for.
USO is the most popular oil ETF in the market today, but it offers an imperfect way of tracking the spot price of a barrel of oil because it invests in near-month Nymex futures contracts rather than in oil. By owning these derivatives, USO’s returns can diverge significantly from the spot price of oil.
This type of complexity stemming from other-than-plain-stock funds also has tax implications. ETFs trade like a single stock, but when it comes to taxes, it’s the underlying holdings that dictate what tax treatment a fund gets.
For example, if you hold a fund like the SPDR Gold Trust (GLD | A-100), and you decide to sell it after a year, you won’t pay the long-term capital gains tax rate at the time of sale even though GLD trades like a single stock.
That’s because GLD owns physical gold—a collectible, according to the Internal Revenue Service. Collectibles are taxed at a 28 percent tax rate no matter how long you hold them. For taxation details on GLD and other types of off-the-beaten-track fund, check out ETF.com analyst Dennis Hudachek’s “Definitive Guide To 2014 ETF Taxation.”
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.
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.