Risks Associated With ETFs

Exchange Traded Funds (ETFs) were invented in the 1990s and exploded in popularity in the 2000's. The total dollar amount of assets under management in ETFs continues to explode. So they have become very popular with investors, as explained in our article benefits associated with ETFs. But every investor should understand the risks/drawbacks to ETFs.

#1 - ETFs are sometimes not as transparent as they should be

ETFs are generally more transparent than other investment fund types, including most mutual funds. For example, although they are not required to do so, most passive ETFs (i.e. an ETF that is tracking an index) disclose their holdings on a daily basis on their website. And the U.S. Securities and Exchange Commission currently requires actively managed ETFs to disclose their holdings on a daily basis. And since most ETFs track an index, it is generally pretty easy for an investor to understand an ETF because an investor can read the methodology behind the index.

But there are still a few instances where ETFs are not as transparent as they should be:

Let's look at a few examples.

USMC, the Principal U.S. Mega-Cap Multi-Factor Index ETF, tracks the Nasdaq US Mega Cap Select Leaders Index. Even though USMC is labeled as a "multi-factor" ETF, implying that it is tracking an index that selects stocks using multiple investment factors (like value or quality), the ETF doesn't explain which factors are being used. The methodology guide for the index also does not explain the factors being used to select stocks. Instead, the methodology guide as of November 18, 2017 merely states that "additional proprietary eligibility criteria are applied" to determine the stocks in the index.

Luckily, this isn't a very common practice. Most index methodology guides spell out in precise detail how they select and/or weight the securities in the index.

All together, most ETFs are reasonably transparent. Most people would probably agree that as a whole, the average ETF is probably more transparent than many other investment fund types. But there is always room for improvement.

#2. ETFs are built around indexes, but not all indexes are created equal.

ETF investing is all about index investing, as most ETFs seek to track an index. When the ETF industry was started, the first ETFs were based on long established indexes like the S&P 500 index. But there are now 2,340 ETFs in existence, and collectively they seek to track the investment results of over a thousand different indexes.

Originally, ETFs followed indexes that were invented by third-party companies like Standard & Poor's or Dow Jones and the original set of indexes were generally well-known and "tested". As the ETF industry has grown, the number of indexes has grown, and it has become harder to have faith in the quality of the indexes.

Many of the newer ETFs follow indexes that were just recently invented. Often, someone thinks of an idea for an ETF, and then hires an index provider to create an index based on that idea. Unfortunately, many of these new ETFs and custom indexes are based on marketing ideas and not necessarily great investing ideas -- i.e. what type of ETF will attract assets in a highly competitive ETF market place?

Many of these newer indexes have no track record or history at all, so it is difficult to even analyze them. Some index / ETF providers will put together "backtest" data to show how the index would have theoretically performed had it been in existence in the past. But it can difficult to completely trust backtest data. Does the newly invented index have great backtesting results because the index creator had the benefit of hindsight, and was able to invent a methodology that he or she knew would have great performance? It is hard to say.

#3. Some ETFs track an index put together by the ETF's sponsor

In 2012, the ETF industry start building/using their own indexes on some ETFs rather than using indexes from third-parties like S&P or MSCI. Wisdom Tree, for example, generally provides the index for all of their ETFs. Is that a bad thing? Probably not. Most index providers will build whatever custom index an ETF sponsor can think of, so there probably is little difference between Wisdom Tree providing their own indexes and other ETFs hiring third party index companies to build a custom index. The challenge to the ETF investor is the same: is there merit to investing based on a particular index?

#4. Some ETFs are actually an exchange traded note (ETN), which means you are trusting the bank that issued it.

ETP TypeCount
ETF2,233
ETN107
Total2,340


Read our article on the difference between an ETF and an ETN.

#5. ETFs can be small and thinly traded.

The top 100 ETFs in size account for 77% of all the assets held by ETFs. The other 2,240 ETPs are really pretty small in size. And there are lots of small ETFs with low trading volumes:

ETFsETNsTotal
Total2,2331072,340
Trading volume below 10,000 shares a day80075875
Percentage35.83%70.09%37.39%

What does this mean for you?

Issue #1 - There may be a difference between the market price per share of the ETF and the underlying net asset value (NAV) per share.

ETFs are traded on a stock exchange, with investors buying and selling them to each other. Theoretically, the "market price" or "trading price" of an ETF should match the value of the underlying assets that the ETF owns, net of liabilities for fees and expenses (referred to as the net asset value of the fund, or "NAV"). But that's never really exactly the case - there is almost always a small difference between the stock price of an ETF and it's NAV per share. You can track this difference by going to each ETF's website, which discloses every day what the NAV per share is. Normally, this difference is small and you don't have to worry about it.

The reason that an ETF generally trades at a price close to its NAV is because of the unique way that ETFs function. If an ETF's trading value starts to deviate from its NAV, the ETF will issue additional shares (or redeem shares), thus forcing the trading value of the ETF to be closer to its NAV. This process is explained in our educational article ETF mechanics.

With a smaller ETF, there is a greater chance that the stock price of the ETF will not match the NAV per share, because the normal process the ETF uses to issue or redeem additional shares is more difficult. Why is that a risk? If you buy an ETF that has a lower NAV per share than what you just paid for the ETF, your chance of losing money on that purchase goes up. Odds are, the difference between the stock price of the ETF and the NAV per share will eventually shrink, which means you will lose money.

Issue #2 - You may need to be careful about how you execute trades with small ETFs.

When you buy or sell a stock or an ETF through a broker, you can execute trades in a variety of fashions. The two most common methods are:

A market order is where you tell your broker that you will buy or sell the security at whatever the prevailing price on the stock market currently is. A limit order is where you tell your broker than you will buy or sell the security, only if you receive the minimum price that you specify at the time you place the order. If you don't receive the minimum price, then your order is never executed.

With large cap stocks like Pepsi or Amazon, you don't have to worry too much about how you execute trades because if you issue a "market" order on a stock, odds are your trade will be executed within seconds and it will be executed at the price you are expecting (the current market price). This is the case because the trading volume is high and at any one point in time there are lots of buyers and sellers who have placed orders that are open to buy or sell the stock at values that are close to the current market price. Stated another way, for a highly traded stock like Pepsi or Amazon, the differences, or "spreads", between "bid" and "ask" prices are small. With the stock market, any open order to buy a stock is called a "bid" and any open order to sell a stock is called an "ask".

Small ETFs can be trickier to buy and sell because market orders can be risky. If you buy or sell a small ETF with a market order, the trade may be executed at a price you aren't expecting. With lower trading volume comes higher differences between bid and ask prices. And there are a much smaller number of open orders sitting on the stock exchange, waiting to be executed. So, occasionally, if you place a market order to sell an ETF that you think has a market value of $35.40 per share, your order may get executed at a price of $30.00 per share, a much bigger difference than you would normally expect.

This happens because buyers and sellers can issue limit orders at whatever prices they want to enter. So even though an ETF can currently be trading at $35.40 per share, a buyer can enter a limit order at any time in which the buyer offers to pay only $30.00 per share (in other words, the buyer "makes a bid" of $30.00 per share). Normally, this low bid would not get executed, because there normally would be lots of other buyers who have entered bids at higher prices, or who have entered a market order bid. But with a thinly traded ETF, there may not be very many "open orders" or "open bids" sitting on the stock exchange, waiting to be executed. So if you enter a market order to sell an ETF, and the only open bid is a bid at $30.00 per share, that order will be executed at the $30.00 per share price. This is an extreme example that is rare, but it can happen.

So be careful with small ETFs. Always execute "limit orders" rather than market orders. You can save yourself hundreds of dollars by just being a little more careful.

#6. ETFs can have "tracking errors".

ETFs are designed to track the performance of the index they are based on. But often an ETF will not perform as well as the index, for the following reasons:

* Management fees to the ETF provider reduce the fund's performance

* The ETF may not be able to execute the day to day trades it needs to make to precisely track the performance of the index. Sometimes its just not practical.

* As explained above, a change in the difference between an ETF's market price per share and net asset value (NAV) per share can help or hurt performance compared to the index.

With the exception of leveraged ETFs and ETFs that buy and sell futures (see below), the tracking errors associated with most ETFs are not that significant and you don't have to worry too much about it.

#7. ETFs that buy and sell futures can have large tracking errors.

Some ETFs track their index by buying and selling futures. ETFs that track commodities typically use futures, as well as many leveraged ETFs. There are special risks associated with these ETFs, mainly the fact that they can have large tracking errors. Because of the complexities of the futures markets, it can be difficult to be constantly buying and selling futures without losing money, which inevitably will impact the performance of the ETF. UNG and USO, for example, are two really popular ETFs that are designed to track the prices of natural gas and oil, but they are notorious for doing a poor job of properly tracking the prices of natural gas and oil over long periods of time. Read our article on the risks associated with ETFs that buy and sell futures.

#8. The sponsor of the ETF or ETN may suspend the creation and issuance of new shares

One way that ETFs and ETNs manage to keep their net asset value (NAV) close to their stock market price is by issuing, when necessary, new shares. By issuing new shares, the gap between the NAV and market price shrinks. However, ETFs and ETNs are allowed to suspend issuing new shares. This means that there is a greater chance that the NAV and the market price will be significantly different. This mostly seems to happen with ETNs, for whatever reason. View our list of ETPs that have suspending issuing new shares

#9. Are there too many ETFs?

How many ETFs do we need? The mutual fund industry has to some degree lost favor with investors because there are too many mutual funds in existence (15,000+), and it seems impossible to filter through them in order to pick one. The ETF industry has exploded in popularity partly because it seems easier to identify and select ETFs than mutual funds. As the number of ETFs continues to grow, at what point are there too many?

#10. Information on an index is often hard to track down

Although most ETFs have a website that discloses information about the fund and the name of the index that it is seeking to track, the ETF is not required on its website to include the ticker symbol of the index, nor a link to the website of the index. So if you want to read more information about the index, you often have to find it yourself.

It is not always easy to find the website of the index, to find more information about the index. Many index providers have websites that list hundreds of indexes, many with similar sounding names and similar symbols. It can be confusing to know which one is the right one. All together, the index industry publishes over 8,000 indexes, most of which are not used by an ETF. So it can be difficult to wade through the number of choices. And frankly, some of the major index providers have websites that really just aren't that good (although S&P and NASDAQ have easy to use index websites, among others).

Let us use as an example, VYM, the Vanguard High Dividend Yield ETF, which tracks the FTSE High Dividend Yield Index. This is one of the largest ETFs in existence, with total assets over $10 billion. We couldn't find very much information about the "FTSE High Dividend Yield Index" on FTSE.com. We also couldn't find very much information by Googling "FTSE High Dividend Yield Index". Vanguard's website merely says that VYM "Provides a convenient way to track the performance of stocks that are forecasted to have above-average dividend yields.". It is hard to find more details.

#11. Index symbols are confusing

ETF investing is all about index investing, but getting information about a particular index is not as easy as it should be. For one thing, there is no simple, clear system of giving every index a symbol that is universally used (indexes have symbols, just like stocks). The index provider refers to the index using one symbol, and then the two major professional data services (Bloomberg and Reuters) will use their own index symbols. And the large, free finance websites like Google Finance and Yahoo Finance will use another symbol.

Let's look at an example. S&P states on their website that the S&P Composite 1500 Index has a ticker symbol of SPR. If you download the Factsheet from S&P's website, it also lists a Reuters ticker symbol of .SPSUP. On Google Finance, the symbol "SPR" doesn't work but you can pull up the index using both SP1500 and SPSUPX. On Yahoo Finance, you can pull it up using the symbol ^SP1500. On the Wall Street Journal's website, you use SPSUPX. Its very confusing. We don't know where the symbol "SPR" used by S&P actually works.

#12. Historical index information is not always readily available

Index providers have to make money, so they carefully guard their index information, and some index providers seem to guard their information more than others. But sometimes, in order to analyze an ETF, you have to have historical information on the ETF's index, and you just can't get it. If the ETF is an older ETF, it often is not critical to know much about the index, because you can just look at the performance history of the ETF itself. But on a newer ETF, you need to be able to look at the historical information of the index, and many times you cannot easily get such information. The information is not available on any free website like Google Finance or Yahoo Finance, and the index provider's website does not always let you download the information.

Our hope is that some day the Securities and Exchange Commission will adopt a rule requiring that any index used by an ETF should be in the public domain, and either the ETF or the index provider has to make the index data readily downloadable from a website. Maybe it will take a new law to make that happen.

#13. Total return indexes are not always available

A total return index is an index that combines the market prices of the securities in an index with any dividends related to the securities in the index, so that you can see the total return of the securities in the index. Many indexes also have a comparable total return index, but many do not. Sometimes, it is important to analyze an ETF using a total return index, and it is not available.

#14. Global ETFs can be difficult to analyze

One benefit to ETFs is that you can easily invest in markets around the world. But it can be difficult to analyze the performance of a global ETF. First, if the global ETF does not employ some form of foreign currency hedging, the net asset value and performance of that ETF can be significantly impacted by changing exchange rates. It is can be difficult to know whether the poor performance (or good performance) is due to changing currency rates, or due to the performance of the foreign market.

Some global ETFs use foreign currency hedging to mitigate the effects of changing currency rates on the ETF. But that also creates a difficult situation for the ETF investor to analyze, because information on indexes denominated in foreign currencies is not easy to find. DBEU, for example, attempts to track European stocks, and uses foreign currency hedging. So it theoretically should track an index that tracks European stock markets denominated in Euros. But it is not easy to find information on European stock markets denominated in Euros. So it is difficult to know if DBEU is successfully tracking European stock markets, and what the effect of the currency hedging really is.

#15. ETFs may be encouraging too much active trading and turnover

There is some concern in the investment community that because they are so easy to trade, investors, especially retail investors, may be overtrading ETFs. If ETFs cause investors to trade more, then ETF ownership could result in increased transaction costs and ill-advised market-timing behavior, both of which might reduce investor returns. But it is difficult to filter out the trading that occurs with the ETFs that are designed for traders, like the leveraged and inverse ETFs, from the trading that occurs in the ETFs that are held by long-term investors (passive ETFs like SPY).

#16. Leveraged 3x ETFs can kill you

One reason for the growth of the ETF industry is that ETFs make it easy to invest using leverage. As of today, there are 123 leveraged ETFs. To give you some feel for how popular they are, the total average daily trading volume of these leveraged ETFs is 185,537,491. But they are highly controversial, because if you are holding one of these leveraged 3x ETPs during a major downturn, you can get virtually wiped out.

#17. ETFs can change their index midstream

IUSV, the iShares Core S&P U.S. Value ETF, adopted the S&P 900 Value Index on 1/27/2017. Prior to that, it tracked the Russell 3000 Value Index. IUSV has been in existence since July 2000. This is a dramatic change, as the Russell 3000 Value Index includes small cap stocks, whereas the S&P 900 is large and mid cap stocks only, without small caps. It will forever be difficult to analyze the long-term performance of IUSV because of this change. Unfortunately, ETFs change their indexes all the time. You can use our tool recent ETF investment policy changes to keep up with recent index changes by ETFs.

#18. ETFs can change from actively managed to passively tracking an index midstream

Alpha Architect initially launched QMOM, IMOM, QVAL and IVAL as actively managed funds. On January 31, 2017, Alpha Architect changed these funds to be index funds based on indexes that Alpha Architect had built. The newly updated Prospectus for these funds states that "prior to January 31, 2017, the Fund was actively-managed using a quantitative strategy substantially similar to the methodology of the Index".

#19. An actively managed ETF can change portfolio managers and investment strategies midstream

It's hard to keep track of the changes.


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