Exchange-Traded Funds

An ETF (Exchange-Traded Fund) is a diversified investment fund that holds a basket of assets like stocks, bonds, or commodities, trading on a stock exchange like an individual stock throughout the day, offering broad market exposure, lower costs, and diversification for investors. ETFs aim to track a specific index (like the S&P 500) or theme, providing an affordable and flexible way to invest in entire markets or sectors. They can be bought and sold throughout the trading day on an exchange, with prices fluctuating continuously. Many are passively managed, designed to mirror the performance of a market index and often have lower expense ratios (fees) compared to actively managed mutual funds. ETFs have some structural advantages relative to mutual funds but it’s important to remember that ETFs have risks like all investments. A little due diligence can go a long way before purchasing an ETF, so don’t judge a book by its cover.

Popular Asset Types of ETFs           

• Actively managed ETFs: These ETFs don't target an index. Instead, portfolio managers make decisions about which securities to buy and sell.  They offer benefits over passive ETFs, but they charge higher fees.
• Passive ETFs: aim to replicate the performance of a broader index, either a diversified index such as the S&P 500 or a more targeted sector or trend.
• Bond ETFs: Used to provide regular income to investors. Distribution depends on the performance of underlying bonds, which may include government, corporate, and state and local municipal bonds. Unlike their underlying instruments, they do not have a maturity date.
• Industry or Sector ETFs: A basket of stocks that track a single industry or sector, like automotive or energy. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with growth potential. 
• Commodity ETFs: Invest in commodities like crude oil or gold. They can diversify a portfolio. Holding shares in a commodity ETF is less expensive than owning the physical commodity.
• Currency ETFs: Track the performance of currency pairs and can be used to speculate on the exchange rates of currencies based on political and economic developments in a country. Some use them to diversify a portfolio, while importers and exporters use them to hedge against volatility in currency markets.
• Bitcoin ETFs: These ETFs expose investors to Bitcoin's price moves in their regular brokerage accounts by purchasing and holding Bitcoin as the underlying asset. 
• Ethereum ETFs: Spot Ether ETFs provide a way to invest in Ether, the native currency of the Ethereum blockchain, without directly owning the cryptocurrency.  
• Inverse ETFs: Earn gains from stock declines without having to short stocks.  An inverse ETF uses derivatives to short a stock. Inverse ETFs are Exchange Traded Notes and not true ETFs. An ETN is a bond that trades like a stock and is backed by an issuer such as a bank.
• Leveraged ETFs: A leveraged ETF seeks to return some multiples (e.g., 2× or 3×) on the return of the underlying investments. If the S&P 500 rises 1%, a 2× leveraged S&P 500 ETF will return 2% (and if the index falls by 1%, the ETF will lose 2%). These products use debt and derivatives, such as options or futures contracts, to leverage their returns.
  

"The First Rule Of An Investment Is Don't Lose Money. And The Second Rule Of An Investment Is Don't Forget The First Rule. And That's All The Rules There Are."

Warren Buffett

“Know What You Own, And Know Why You Own It.” 

Peter Lynch

ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.

Here are 6 common risks associated with Exchange Traded Funds.

Risk 1: Market risk

Although ETFs have helped democratize investing, the benefits of the ETF structure don’t remove any of the inherent risks of investing in stocks, bonds, real estate, and other asset classes. The primary market risk of an ETF is the potential for the value of its underlying investments to decline due to general market movements. An ETF is simply a wrapper for its underlying assets (stocks, bonds, commodities, etc.), so if those assets lose value, the ETF will as well. 

Risk 2: Tracking error

Tracking error is the risk that the performance of an ETF falls short of the index to which it’s tied and may be caused by many reasons. Tracking error is relevant for index-based ETFs only; it’s typically not an issue for actively managed ETFs.

There are several factors that can create index tracking error in an ETF, including:

• The skill and experience of the portfolio manager
• Taxes and capital gains distributions (which some indexes don’t have to pay)
• Whether the ETF fully replicates or uses a representative sample of the index
• ETF fees and commissions (which reduce what investors get to keep)
• The ETF’s trading costs
• Performance differential from cash

Risk 3: Liquidity

The liquidity of an investment is defined by how easy it is to buy and sell without significantly impacting its price.When it comes to ETFs, there are three sources of liquidity:

• Secondary market (on-screen) liquidity: Investors trading ETF shares on exchanges; reflected in the quoted trading volume and bid/ask spreads of an ETF
• Primary market liquidity: The ability of authorized participants (APs) to create and redeem large blocks of ETF shares in response to supply and demand in the market
• Liquidity of underlying asset class: The liquidity of an ETF is also impacted by how liquid the securities are in which it invests (i.e., U.S. large-cap stocks are more liquid than emerging market bonds)

Risk 4: Sector concentration

When considering purchasing an ETF, it’s a good idea to go beyond the fund’s name to understand the holdings in its portfolio. Most ETFs disclose their entire portfolio on a daily basis. Although an ETF may appear diversified, it can have tilts to certain sectors that can significantly impact its performance.

Dividend ETFs, which some equity investors use for income, may provide an illustration. These ETFs’ portfolios may be focused in sectors like utilities, financials, and consumer staples because historically those industries have tended to have high dividend yields. Bottom line: Don’t judge a book by its cover and make sure you understand exactly what you’re getting when you buy an ETF.

Risk 5: Single-stock concentration

Investors may also want to check to see if an ETF has outsized positions in particular stocks. When researching ETFs and their tracking indexes, some online tools and websites let investors check the percentage of the portfolio in the 10 largest holdings, as an example.

Single-stock concentration has become a hot-button issue because some of the largest technology stocks have gotten so big that they’ve started to dominate some benchmarks that weight stocks by market capitalization. That means a relatively small handful of stocks can have an outsized impact on an index’s performance.

Risk 6: Shutdown risk

There are a lot of ETFs out there that are very popular, and there are a lot that are unloved. Over the last 5 years, an average of 150 ETFs closed per year (Source: EFT.com).

An ETF shutting down is not the end of the world. The fund is liquidated and shareholders are paid in cash. It's not fun, though. Often, the ETF will realize capital gains during the liquidation process, which it will pay out to the shareholders of record and that could mean an unnecessary tax burden. There will also be transaction costs, uneven tracking, and various other grievances. One fund company even had the gall to stick shareholders with the legal costs of closing the fund (this is rare, but it did happen).

“The market is a device for transferring money from the impatient to the patient.” 

Warren Buffet