Investing in ETFs involves market risk, liquidity risk, and tracking error, with potential deviations of up to 1% annually.
Market Risk
Market risk is the risk of losses due to factors affecting an asset class. It is determined by the overall performance of financial markets. This risk is always present in all investments, and this is also true for ETFs.
Economic volatility
ETF development is expensive under economic cycle conditions. In times of economic downturn, losses in ETFs that follow broad market benchmarks are large. In the case of the 2008 financial crisis, the S&P 500 ETF (SPY) lost about 37% of its value. In times of economic downturn, your ETF investment may become significantly less valuable.
Geopolitical events
Conversely, factors such as (geo)political tensions and/or events (war, political instability) tend to increase market volatility. This led to ETFs related to the European market experiencing significant intraday volatility when dealing with Brexit. Global events always affect ETF positions, so it is imperative for investors to be vigilant in this case as well.
Specific industry risks
ETFs targeting specific industries (such as technology or energy) are particularly susceptible to issues in specific industries. For example, an ETF focused on oil and gas could plunge if oil prices plummet due to oversupply or if there are safety risks in oil-producing regions. Any risk associated with concentrated investments in a particular industry is market risk.
Historical Volatility
As history has shown us time and again, markets can be extremely volatile. At the height of the COVID-19 pandemic in March 2020, the VIX (also known as the “fear index”) jumped to 82.69, indicating extremely volatile markets. Recognizing historical volatility is beneficial for investors in anticipating and managing market risk.
Diversification Strategies
While ETFs achieve diversification by collecting a variety of assets, they are not inherently immune to market risk. The impact of this risk can be managed by allocating their investments across different categories such as bonds, commodities, and real estate. Managing market risk is ultimately a diversification strategy.
Liquidity Risk
This risk relates to the possibility that an investor will not be able to quickly buy or sell an ETF while it is trading at a price far from the last quoted price. This can present significant problems for those seeking quick access to liquidity or those who have invested heavily in illiquid ETFs.
Trading Volume
The liquidity of an ETF can be significantly reduced if you need to make a large withdrawal (e.g., you lose your job and need to tap into your emergency fund). Take, for example, an ETF that only trades a few thousand shares per day – it’s not always easy to sell in a hurry (and in large quantities) without affecting the price. The higher the trading volume, the higher the liquidity, as it means you can buy or sell without significantly affecting the market price.
Bid-ask Spread
The bid-ask spread represents the difference between the price you can buy the ETF (the ask price) and the price you can sell the ETF (the bid price). Lack of Depth – A wider spread represents poor liquidity. As a rule of thumb, the larger the spread, the less liquid the asset is (e.g., a $2 spread on the above ETF indicates low liquidity). Tighter spreads generally mean higher liquidity and lower costs per trade.
Market Depth
Market Depth: The amount of trading volume that the market can absorb before the price changes. ETFs with deeper markets are more capable of handling large trades with less impact on price. On the other hand, investors determine market depth when they want to know how many trades they can make without affecting the market too much.
Subscription and Redemption Mechanism
As you know, ETFs have a creation and redemption process where Authorized Participants (APs) create or redeem shares based on market demand. However, during periods of market stress, APs can be challenged, reducing the motivation of ETs). It is important for ETF investors to understand APs because they help keep ETFs aligned with fund value; but they are also not very efficient in keeping funds liquid.
Tracking Error
Tracking error indicates the difference in the performance of an ETF from the performance of its benchmark index. Large tracking errors can defeat the purpose of investing in an ETF, since investors are buying the ETF, not the index it tracks.
Causes of Tracking Error
Tracking error is caused by a variety of factors:
- Expense ratio: All ETFs have management fees, which can result in small deviations from the benchmark. For example, a 0.5% expense ratio means that the ETF needs to perform 0.5% higher than the benchmark to hit the benchmark after fees.
- Cash drag: To handle liquidity, an ETF may hold a small amount of cash, causing it to underperform a fully invested index. This is called cash drag, and it becomes a significant factor in tracking error.
- Sampling: Many ETFs also use a sampling approach to track their benchmark, rather than holding the underlying stocks at all times. This causes the ETF’s performance to differ slightly from the performance of the index.
- Dividend timing: Differences in dividend timing and dividend reinvestment between an ETF and its benchmark can be another source of tracking error.
Quantifying Tracking Error
Typically, tracking error is measured as the standard deviation of the ETF’s returns relative to the index. A low standard deviation means more closely tracking the benchmark. This means that ETFs with lower tracking errors follow their benchmarks more closely than ETFs with higher tracking errors.
Implications for Investors
For investors, tracking error essentially means that the performance of their ETFs may deviate from the index they are trying to mimic. This difference is critical for long-term investors, who need to know what the tracking error is (i.e. how closely it tracks the original price) versus the target they have set. To manage expectations about the type of tracking error to expect, one needs to understand the possibilities.
Mitigating Tracking Error
Investors can reduce tracking error by:
- Low-Cost ETFs: Choose ETFs with lower expense ratios—the lower the tracking error, the better.
- Monitoring ETF Performance: Regularly checking the performance of an ETF against that of its benchmark can help identify major differences early on.
- Understanding ETF Structure: Knowing whether an ETF uses full replication or sampling can provide insight into potential tracking error.
