What nobody told you about ETF’s

What nobody told you about ETF’s 

Today I want to talk about Exchange Traded Funds. ETF’s are an ever increasing industry with a total market capitalization reaching well over 4$ trillion in 2019. They are also becoming more and more important for the small investor as they offer a low cost option to participate in the stock market. However there are some risks associated with ETF’s that in my experience many small investors are not aware of. During times like these, where all assets are rising, ETF’s seem like the perfect investment. However during times of crisis the hidden risks could cause a lot of devastation, especially when you are not aware of them. In this article I want to discuss what I think are some important aspects to consider when investing in ETF’s and the hidden risks. I will also talk about positive aspects of ETF’s.

Pro

ETF’s are a great tool especially for the small investor. Before their invention you had to buy mutual funds, if you wanted to invest in the stock market but didn’t have enough capital to create a diversified portfolio yourself. The problem with mutual funds however is that they are associated with high costs of around 1% to 2% p.a. and these are just management fees. Additionally some funds have a performance fee, which usually applies to the gains the fund makes above a certain level. Even though 2% might not sound so much, as you can see in my article on compound interest, even a small difference in the interest rate can make a huge difference in the return you will get, especially over long periods of time. The second big issue with mutual funds is their performance. According to an article on CNBC.com well above over 80% of mutual funds underperform the S&P 500 over long time periods (10+ years). Further a study from UCLA found good performance is mostly present in funds that apply growth strategies or have small net asset values. However the authors conclude that these types of funds typically have the highest expenses so that their performance diminishes net of fees (see below for sources). ETF’s are a promising low cost alternative. If you can’t get better returns than the index make sure to at least get the same return at much lower cost. 

Contra

In the first part of this article I discussed the advantages that ETF’s offer (or rather the disadvantages of classic mutual funds). Now I want to talk about some lesser known negative aspects and maybe help you to become aware of the risks associated with ETF’s.

1. Physical versus Synthetic Replication

The first aspect is the method of replication used by the fund. In my opinion this is one of the most important aspects to consider, as it allows you to reduce your risk tremendously with almost no work at all. The two methods to distinguish are physical replication and swap based replication. When a fund uses the physical method of replication it means the fund actually buys all the stocks in the index and holds them in their accounts. On the other hand swap based replication means the fund doesn’t own the stocks, but uses derivatives, in this case swaps, to get the same exposure to the market as if it would own the stocks. In my opinion the swap based method is not suited for the long term investor and makes only sense when you use the ETF for short term trading purposes. Even though ETF’s that use swaps to replicate an index usually have lower fees, there is a huge risk of total loss during a crisis. The reason for this is, that the counterparty to a swap usually is a bank and when the bank goes broke in times of financial crisis you lose your investment. Swaps were also the product that caused the financial crisis of 2008/2009 to spread globally. It is imperative for investors to know this difference, take a little time to read the prospectus and then go for a fund that uses physical replication.

2. Crowding out Effects

The next aspect is the possibility of crowding out effects occurring in a future crisis. When many ETF owners want to sell at the same time, the funds have to liquidate stocks in order to raise capital. As most of the money in ETF’s goes into the S&P 500, in a time of crisis a lot of funds would have to sell stocks that are listed in the S&P 500, thereby pushing down the stock’s prices. This could lead to more selling from investors and create a self-reinforcing cycle. Contrary to that, mutual funds don’t all have the same stocks so even if all funds have to sell, the wouldn’t sell the same stocks. 

3. ETF Bubble?

The last aspect I want to talk about is something I have found very little in while researching. It is just an idea that I had, which is that ETF’s could be the next big bubble. A key characteristic of assets that develop into a bubble its that everyone and especially small investors are euphoric about it. Today the only asset class that could match this description are ETF’s. Every small investor buys ETF’s and everyone that has nothing to do with finance knows about them. On the other hand one aspect that is missing is the expectation of huge returns as people are aware that they will only get the return of the index. Further the huge inflow of capital into ETF’s over the past years leads to inflated prices. This is especially the case with bad companies that get bought just because they are part of the index. Could it really be that prices across the board are artificially high because of the influence of ETF’s and that we will see huge losses in the future, especially in stocks that are part of the big indices?

Conclusion

As we have seen ETF’s also have some risk factors inherent in them. In my opinion these risks are not the biggest problem. The big issue is that most people are not fully aware of them. I think ETF’s can still be a great investment vehicle especially for small investors, but investors need to get familiar with what they buy and learn about all the risks. This will enable them to plan for these risks in their security selection, i.e. select an ETF that uses physical replication. Also I think, whenever it is possible from a cost perspective, you should hold your investments directly in your accounts and not use a middleman like an ETF or a mutual fund. 

Sources: 1. https://www.cnbc.com/2019/03/15/active-fund-managers-trail-the-sp-500-for-the-ninth-year-in-a-row-in-triumph-for-indexing.html 2. Mutual Fund Performance: An Analysis of Quarterly Portfolio Holdings; Mark Grinblatt and Sheridan Titman; The Journal of BusinessVol. 62, No. 3 (Jul., 1989), pp. 393-416

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