The risks of using ETFs for long term investing
An ETF (Exchange Traded Fund) can be a great investment option because it allows diversification even with a small capital. Consider for example the SPY, an ETF tracking the S&P500 index. Since you cannot invest directly in an index, how can you replicate the S&P500 results? There are three main options:
- you can buy shares of the 500 companies included in the index. Indeed, not an easy task, both from a technical and a capital requirement point of view. Not to mention the commissions
- buy a mutual fund (also called unit trust), where an active manager tries to beat a benchmark index. Looking at the statistics, it is very hard to find a fund able to do that consistently
- invest in the SPY ETF. This way, you can track quite accurately the S&P500 index. Being a passive replication, you do not have to pay a lot of money to a fund manager who tries (and often fails) to beat the index. Moreover, you do not need a large capital.
Everything sounds great, don’t you agree? In addition, according to CNBC, ETFs are becoming increasingly popular. Just to cite a few numbers, in 2008 investors had 531 billion US$ in ETFs. In 2017, it was 3.4 trillion US$. On top of that, there are ETFs tracking everything, from countries to commodities and precious metals (like Palladium). Now, before you open your brokerage platform to look for ETFs for your portfolio, some words of warnings.
3 Risk Factors of ETFs
Like every financial instrument, ETFs carry risks. You can find here three of them:
- Physical vs Synthetic ETFs. Physical ETFs work by holding the components of what they track (e.g., the 500 stocks of the S&P500 index with the same proportion). Synthetic ETFs try to get a similar result using derivative instruments. Even though it may work most of the times, it is not clear what would happen in case of huge volatility or recession. There was no stress test on that for synthetic ETFs, and the counterparty risk (i.e., the issuer will not fulfill its obligation) is higher
- Liquidity. It is true that you can find ETFs tracking almost everything. At the same time, you must be careful about the liquidity. As a matter of fact, if the volume is low and the underlying is something not heavily traded, it may be hard to exit at the price you want
- Leveraged ETFs. There are some synthetic ETFs that try to give you 2 or 3 times the return of the underlying. For example, SSO is a 2x ETF tracking the S&P500. Hence, if the SPY is up 10%, this ETF should give us 20%, right? No! I can explain it in detail, but the main reasoning is that when the price drops, you also have a double loss, and you need more to breakeven.
To summarize, you may use ETFs for trading as they allow exposure to many markets. At the same time, for a long-term investing portfolio, I would only consider physical and liquid ETFs where the underlying is also associated with a high volume.