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Investors shouldn’t ignore the risks tied to ETFs

Yong Hian Lim/Getty Images/iStockphoto

John Reese is chief executive officer of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service

As I wrote about in a previous column, the benefits of investing in exchange traded funds are well-known – they cost less than many mutual funds, their holdings are easy to monitor, they are easy to trade and they offer tax advantages. But all may not be perfect in ETF-land and there are potential risks to think about and understand.

On the plus side, ETFs trade like stocks, so an investor can buy and sell them at any time of the day, rather than only once as is the case for a mutual fund.

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Some professional investors use ETFs as a hedge for their actively traded positions, and the extra liquidity allows them to profit from small changes in price during the trading day. But trading fees are a downside for retail investors. An investor with a big chunk of money to invest could make just one trade and pay one commission and be done. But an investor setting up a repeat trade might rack up sizeable brokerage commissions, potentially blunting the benefit of lower fund costs overall.

Selection risk is another concern. There are nearly 2,000 U.S.-based ETFs (and over 4,800 worldwide) and they don't necessarily go about investing in an index in the same way. Generally speaking, ETFs track a broad benchmark, say the Standard & Poor's 500. These benchmarks are weighted by market capitalization and, thus, tend to emphasize stocks of larger companies. But some ETFs weight their portfolio stocks equally, which gives more prominence to smaller or less liquid stocks. Other ETFs use some other fundamental analysis or super niche strategies.

Investors might assume that they are getting diversification by investing in an ETF that tracks a broad benchmark. But a market-cap weighted fund might be too concentrated in a handful of dominant stocks, as ETFs can be when investing in a specific sector or region. Investors who put together portfolios of several different ETFs to achieve diversification – this is what the so-called robo adviser firms are all about – could also risk over-concentrating in certain stocks or sectors.

Diversification is also hurt when a portfolio holds stocks that tend to trade together. Morningstar makes this point in a recent research note comparing Vanguard's consumer staples ETF with its real estate fund.

The top ten holdings in Vanguard's consumer staples fund (VDC) make up 60 per cent of its portfolio but represent such disparate companies and products that they aren't necessarily correlated. The top ten holdings of the real estate ETF (VNQ), meanwhile, make up only 35 per cent of the portfolio, but they are stocks of companies that do the same thing, so they trade in lock step. Investors hoping that an ETF will bring them exposure to different pockets of the market need to check that the fund they are considering does just that.

There are funds that are actively managed but look like they are passively managed, because the manager invests in so many stocks it is almost like an index in sheep's clothing.

Then there is what could be called popularity risk. Seth Klarman, founder of the Baupost Group, recently wrote "The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become."

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Passive investing has skyrocketed in popularity with rising markets and investor scrutiny of fees. According to The New York Times, Vanguard, the dominant passive investor in the U.S., has taken in 8.5 times the assets in the last three years as all other mutual fund firms combined. The massive amount of assets in ETFs, which now stand at over $4-trillion (U.S.) according to a recent Wall Street Journal article, have the potential to push valuations of the top index constituents higher -- running they risk they get disconnected from the underlying fundamentals. This is what transpired in the late 1990s. While valuations today are from far from where they were then, investors should be mindful of this hidden risk.

The question becomes what will happen when markets have sudden and sharp correction or enter the next bear market? If investors all start hitting the "sell" button at once, a downturn could be exacerbated.

That's because of the way ETFs are sold. When a mutual fund investor asks for her money back, the fund manager can pick the stocks that will be sold to raise the money to cover that redemption. With an ETF, the entire basket of stocks or securities is sold. This is an important point, because it means there's a chance that more selling of ETFs impacts a wide net of securities due to the selling mechanism of ETFs. This could cause a cascading type effect that may accentuate downside volatility when it comes.

While I don't think these risks offset the benefits ETF provide investors, I think it's important for investors to look at both the pluses and minuses inherent when investing in ETFs. When a particular idea gets popular, investors tend to pile on without understanding both sides, good and bad, of the investing equation.

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About the Author

John Reese is CEO of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. More

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