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This chapter is from the book

Risks of Investing with ETFs

Despite their advantages, ETFs are not risk free. No investment is. However, understanding the risks that are particular to ETFs helps investors prepare for unforeseen events and build their portfolios.

Index Risk13

As discussed previously, ETFs are designed to match an index, and are passive investments.14 In contrast to a mutual fund, they are not actively managed, which provides many benefits, as seen earlier. However, because an ETF is not actively managed, it will not sell a security if the security's issuer is in financial trouble—unless the security is removed from the index. This means that the fund will move up and down with the index and the fund manager will not take defensive positions, or sell losing positions, in a market downturn. This also means that the manager won't increase exposure to positions that it anticipates increasing in value, either. This lack of management means that investors are placing their money with an index, not a manager, and their fortunes are related to the performance of the index.15 The best way for an investor to deal with index risk is to understand what is in the index and the rules governing what goes into, or out of the index, as covered in the fund's documentation.

Tracking Error16

In addition to the risk of their investment being exposed to the movements of the index, investors also are at risk when the fund does not match the performance of the index, a situation known as tracking error.

Tracking error represents the difference between the performance, or return, of the fund's portfolio and the underlying index. Tracking error occurs for a number of reasons. The first is that a fund has expenses that an index does not have, because it incurs costs when it buys and sells securities.17 The frequency of these transactions, such as how often a fund rebalances its portfolio, can increase the costs that increase tracking error and diminish a fund's performance.

Another reason for tracking error occurs when a fund holds cash, which will earn a different rate of return than funds invested in the portfolio and cause a deviation in returns between the index and the fund. (At some times the cash may perform better than the fund.) With ETFs, however, the amount of cash held tends to be small—maybe some 0.1% to 0.2% of the total assets under management.

Certain ETFs may exhibit tracking error because the weights of the securities in their portfolios do not match those in the fund. When the weights are based on market capitalization, this will not be much of a problem, because the weights are tied to the capitalization of the stocks, and if a stock moves up in price in the index, that will be captured in the fund. The difficulty arises when a fund assigns weights by another means, such as equal weighting or some arbitrary method of weighting. In these cases, changes in the values of the securities in the index may not show up in the fund until the fund is rebalanced, where the fund's securities are adjusted to match those in the index. This lag can induce tracking error.

Another source of tracking error comes from the fact that many funds do not hold all the securities that make up the index. There are two ways for a fund to track an index. The first is replication, whereby the fund holds all the securities in an index in the same proportions as in the index. The second is by representative sampling, whereby the fund uses a sampling methodology to select securities that it believes will provide the same performance as the entire portfolio. This methodology usually produces larger tracking errors than if the fund bought the whole index. The amount varies depending on the quality of the sampling process.

Recently, a major problem has arisen with certain types of ETFs that exhibit significant tracking error—leveraged ETFs and inverse ETFs. Leveraged ETFs, also called ultra funds, are intended to multiply the performance of the index or benchmark they track. For example the Proshares Ultra S&P 500 (SSO) is intended to deliver twice the daily performance of the S&P 500. Inverse ETFs, also called short funds, intend to deliver the opposite performance of the index they follow. For example, if the S&P 500 goes up 10% in one day, the ProShares Short S&P 500 (SH) is supposed to fall 10%. Investors can use inverse ETFs to profit in a falling market without having to engage in the stock borrowing process that is traditionally used to short an ETF. Leveraged and inverse ETFs do this by using derivatives to trade that market.

In addition, leveraged inverse funds are intended to provide a leveraged return that moves in the opposite direction to the underlying market's daily move.

Note the use of the word "daily" in describing the returns of the funds. Many investors have mistakenly thought that the multiples also apply over the long term. These funds do not work that way, however. Over the long run, fund performance can significantly deviate from the index, showing great tracking error. The SEC cites two recent examples of how these funds have gone off track:

  • "Between December 1, 2008, and April 30, 2009, a particular index gained 2 percent. However, a leveraged ETF seeking to deliver twice that index's daily return fell by 6 percent—and an inverse ETF seeking to deliver twice the inverse of the index's daily return fell by 25 percent.
  • "During that same period, an ETF seeking to deliver three times the daily return of a different index fell 53 percent, while the underlying index actually gained around 8 percent. An ETF seeking to deliver three times the inverse of the index's daily return declined by 90 percent over the same period."18

Here's how that can happen:

  • "Let's say that on Day 1, an index starts with a value of 100 and a leveraged ETF that seeks to double the return of the index starts at $100. If the index drops by 10 points on Day 1, it has a 10 percent loss and a resulting value of 90. Assuming it achieved its stated objective, the leveraged ETF would therefore drop 20 percent on that day and have an ending value of $80. On Day 2, if the index rises 10 percent, the index value increases to 99. For the ETF, its value for Day 2 would rise by 20 percent, which means the ETF would have a value of $96. On both days, the leveraged ETF did exactly what it was supposed to do—it produced daily returns that were two times the daily index returns. But let's look at the results over the two-day period: the index lost 1 percent (it fell from 100 to 99) while the 2x leveraged ETF lost 4 percent (it fell from $100 to $96). That means that over the two day period, the ETF's negative returns were 4 times as much as the two-day return of the index instead of 2 times the return."19

Leveraged and Inverse ETFs Are Not for Long-Term Buy and Hold Investors

At the moment, with their system whereby they reset daily, leveraged and inverse ETFs are not suitable for long-term buy and hold investors. These ETFs are designed as short-term trading vehicles. The moment an investor holds them beyond one day, she exposes herself to significant tracking error. Because these ETFs reset each day, as shown in the previous example, it is possible for someone who buys one of these ETFs to undergo a major loss, even if the underlying index shows a gain.20

Tax Problems with Leveraged and Inverse ETFs

ETFs have been praised for their tax efficiency. However, leveraged and inverse ETFs, because of their daily resets, can cause an ETF to realize significant short-term capital gains that may not be offset by capital losses.21

Credit Risk

Investors in one form of exchange traded vehicle, the exchange traded note (ETN), need to be aware of credit risk if they buy ETNs. ETNs are senior unsecured debt obligations that are designed to track the total return of an index after subtracting fees. They are not equities or index funds, although they have similarities to those funds. They trade on an exchange, and investors can short them. Their return is linked to the return of a particular index. ETNs provide exposure to sectors and asset classes that can be hard to access cheaply with other types of investments and can be used as a hedging tool.

Whereas ETFs own securities, ETNs own nothing.22 The repayment of the principal and any interest, and payment of any returns at maturity or upon redemption, depends on the ability of the issuer of the ETN to pay. This means, if something happens to the ETN issuer—notably going bankrupt—the investors in an ETN line up with all the other unsecured creditors. Investors who choose to put their money into ETNs need to pay attention to the credit ratings of the issuers, although as the credit crisis of 2008 showed, credit ratings may not be worth much. Remember, the issuers of the ETNs pay the ratings agency to get rated.

Changing Tax Laws

Changes in U.S. tax laws could affect the tax status of ETFs, which could help or hurt investors in a particular ETF, depending on how the tax change affected the fund in question. One area that could be of concern is change in how dividends are taxed. Dividends are distributions of money, stock, or other property that a corporation pays to owners of its stock.

Dividends are classified as either ordinary dividends or qualified dividends. Ordinary dividends, the most common form of distributions, are taxed as ordinary income at an investor's marginal tax rate. Ordinary dividends are paid out of a corporation's earnings and profits and are taxable as ordinary income, not as capital gains.23

Qualified dividends are ordinary dividends that receive the same tax treatment as capital gains—a 0% or 15% maximum tax rate, depending on the investor's tax bracket. The 0% rate applies to investors whose tax bracket is less than 25%, and the 15% rate applies to those whose tax bracket is 25% or higher. To qualify for the 0% or 15% maximum rates, all of the following requirements must be met:

  • The dividends must have been paid by a U.S. corporation or a qualified foreign corporation.24
  • The dividends do not fall under the IRS's list of dividends that are not qualified dividends.25
  • The investor has held the securities for a minimum holding period.26

Repealing or failing to extend the current tax treatment of qualified dividend income could decrease demand for dividend paying securities, which may affect funds based on dividend paying stocks.27 This is scheduled to happen in 2011, when dividends are again subject to being taxed as ordinary income at the investor's highest marginal tax rate.

While the Three Paths investing approach is not built around dividends, certain companies, such as large pharmaceutical companies (featured in some healthcare funds) and utilities (featured in many infrastructure funds), tend to pay decent dividends, so a change in tax law could affect the prices of ETFs holding those stocks.28

Market Capitalization Risk

Many of the companies in both the green and biotech funds have market capitalizations that range from small ($200 million to $1 billion) to medium ($1 billion to $5 billion) in size. By virtue of investing in small- to mid-cap companies, the funds subject themselves to risks associated with these companies. These companies may be startups with little revenue, narrow product lines, inexperienced management, few financial resources, and less stability than larger, more established companies.

These stocks often have more price volatility, lower trading volumes, and less liquidity than larger companies, which could mean that the funds also acquire those characteristics.

Concentration Risk29

One risk from investing in the three paths comes from concentrating your investments in three areas: healthcare, green, and infrastructure. While we do this concentration in a diversified manner, using ETFs to reduce single stock risk, there is still risk from focusing on a particular sector. By concentrating in a particular sector, a fund makes itself susceptible to economic, political, or regulatory events affecting only that particular industry, which may not move the whole market. For example, changes in FDA drug approval processes could affect the fates of healthcare companies, but would have a lesser impact on the stock market as a whole.

Geographic Risk

One variant of concentration risk is geographic risk. Some ETFs are composed of companies in one country or geographic area. This exposes the investor to risks particular to that country or region. For example, in the European Union, many economies are not only tightly interwoven in trading but also share a common currency, the Euro, and its accompanying European Central Bank. Economic problems in one country can quickly spread to others, and because Eurozone countries no longer have control of their currencies and interest rates, they have a more difficult time adjusting their monetary policies in tough times.30

Geographic risk can also arise from environmental factors. Consider the Netherlands, a large part of which lies underwater. If a major storm overwhelmed Dutch flood control structures, there could be major damage to the whole Dutch economy, hurting the performance of an ETF based on Dutch companies.

The geographic risk could also apply to a particular industry in a certain area. For example, much of the U.S. oil and gas industry has its fortunes tied to wells in the Gulf of Mexico. A hurricane could damage a large number of offshore platforms and hurt the stocks of companies in the oil and gas production sector. However, at the same time, the need to repair the platforms could also lead to increased growth in the offshore oil services sector. Risk can play both ways.

Foreign Security Risk31

Investors who venture outside the United States bear risks beyond those associated with investments in U.S. securities. This doesn't mean that you should not diversify geographically, because there may be benefits from exposure to other currencies in reducing overall portfolio risk. Just understand the risks before you take the trip. It's your money after all.

Some of the risks may include greater market volatility (depending on the market), less reliable financial information (depending on the market), higher transaction and custody costs, foreign taxation, and less liquid markets.32 Political instability may make it difficult for a fund to invest in certain countries or repatriate the proceeds of its investments back to the United States.

Many ETFs may be focused on companies based outside the investor's home country. In this case, those companies may have earnings or a stock that is priced in a currency that differs from the investor's home country. This exposes the investor to the risk that currency moves could affect the investor's holdings—advantageously or harmfully.

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