Watch Out: The Risks of ETFs

ETF EDUCATION: ETFs are a great investment vehicle, but investors should be aware of the risks involved

Lee Davidson 24.04.2012
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For most investors, exchange-traded funds (ETFs) and exchange-traded products (ETPs) are the least costly, broadly diversified investment vehicles that are available in the market. However, if investors trade frequently or pursue dollar-cost averaging strategies, ETF trading costs can potentially stack up and erode any cost-savings derived from their lower expense ratios. Additionally, ETF investors face the risk that an ETF may not track its reference index closely—this is called 'tracking error.' Finally, the manner in which many ETFs are constructed exposes investors to counterparty risk. Though, as Morningstar analysts have explained through industry-leading research, counterparty risk is inherent in almost every investment vehicle and is not at all unique to ETFs.

In this latest instalment of our Mornignstar ETF education series, we outline some of the drawbacks of buying and owning ETFs.

Trading Costs
Historically, trading costs have been the primary drawback of exchange-traded funds and products. In a previous article on the benefits of ETFs, costs were shown and proved to be the most reliable predictor of fund performance, and therefore, deserve investors' attention. While ETFs, on average, have the lowest all-in expense ratios compared to mutual funds and other managed investment products, expense ratios are not the only cost investors can incur when investing in an ETF. When determining the total cost of ownership, investors should also consider commissions, sales charges, and other trading costs. In fact, trading costs have been shown to be equally powerful in explaining fund performance as expense ratios (Chalmers et al, 1999). In this regard, it is less clear that ETFs offer a distinct advantage as these costs are primarily a function of an investor's trading habits.

The trading cost structure of an ETF is probably best described via juxtaposition with a comparative mutual fund. In order to buy and hold a mutual fund, investors must not only pay the expense ratio but also a host of other fees including: loads (e.g. commission, sales charges), marketing fees, and trailing commissions. Mutual fund expenses can be cut down by shopping for low-cost distribution channels, no-load funds, or brokers who charge a flat-fee. Often times, no-load mutual funds are available and do not charge per trade creating a tremendous incentive for investors who periodically add new money to their investments (e.g. pound-cost averaging).

By comparison, ETF providers do not charge above and beyond the expense ratio listed on its prospectus. There are no marketing or trailing commissions. However, when purchasing an ETF, brokerage houses typically charge a trading commission--just like trading a stock. If investors trade frequently or pursue pound-cost averaging strategies, ETF trading costs can stack up and potentially erode any cost-savings derived from the lower expense ratio.

In the past few years, however, certain European brokerage houses have adopted commission-free ETF trading on a handful of select ETFs. If your brokerage house offers these types of deals, then you are in luck! The advent of commission-free ETF trading means that one of the chief drawbacks of ETFs relative to traditional funds has been removed.

Tracking Error
Investors who purchase an ETF are relying on it to deliver the underlying index return. However, in practice, ETFs tend to diverge somewhat from their reference indices. "Tracking error" is when an ETF does not perfectly mimic returns of its index.

Some level of tracking error is normal and should be expected. Management fees charged by the ETF provider are a direct (and often the largest) contributor to tracking error. However, even after adjusting for management fees, most ETFs will still have some residual tracking error. Other sources of tracking errors include tax treatment and dividend timing. ETFs using the physical replication method exhibit larger tracking errors compared to ETFs that use synthetic replication.

In practice, the divergence between most ETFs and their reference indices is generally quite small, but investors should be mindful of this difference and seek to understand the reasons behind it when conducting their due diligence.

Counterparty Risk
In recent years, the issue of counterparty risk has been vaulted to the forefront and caused much debate within the European ETF industry, despite the fact that this sort of risk has existed for decades in nearly every fund structure on the planet Counterparty risk is essentially the risk that someone who promises to do something, fails to follow through on their promise.

For ETFs, counterparty risk arises primarily from two practices: securities lending and synthetic replication.

Synthetic replication ETFs track their designated indices via swaps--essentially a bank or other institution's promise to provide the return of the index to the ETF in exchange for the return on a separate asset basket. Investors in synthetic replication funds face the risk that the swap’s counterparty will fail to deliver the index return. In practice, this risk is mitigated via collateralisation of the fund’s swap exposure. In return for assuming this extra risk, synthetically replicated indices tend to offer lower tracking error and lower fees than their physically replicated peers.

Securities lending is a decades-old investing practice where a fund lends some of its holdings (e.g. stocks, bonds, etc) to another market participant for some period of time with the promise that borrower will return them at a later date. Investing veterans will know that borrowing securities in this way is the basis for short-selling. Despite the historical acceptability of this practice, ETFs have recently come under scrutiny for their lending practices. However, several fail-safes are typically put in place to shield investors from counterparty risk associated with securities lending including collateral requirements and debentures. Moreover, ETF investors tend to benefit from this practice as it generates additional income for the fund, which is usually passed through to investors.

For more in-depth analysis, Morningstar's team of ETF analysts has been at the forefront of the industry discussion regarding both synthetic replication and securities lending practices at major European ETF providers.

Lack of Investor Education
Finally, ETFs remain a relatively new investment vehicle. As such, many investors are still learning about these products and how to use them within their portfolios. Unlike the previously listed ETF drawbacks, however, this is not a structural deficiency and can be overcome. At Morningstar, we hope to provide you with the tools and educational content needed to understand how to best use these products in your own portfolio or on behalf of your clients.

Lee Davidson is an ETF analyst with Morningstar

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Lee Davidson

Lee Davidson  is Head of Manager and Quantitative Research at Morningstar.

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