4 Risks of Services Sector ETFs You Should Know

Investing in services-sector ETFs is not risk-free. Market volatility and economic downturns such as the 2008 financial crisis severely impacted many service-sector ETFs as consumers stopped spending money and the bottom fell out of the market.

Many well-known services ETFs saw losses of greater than 20% in 2008, underscoring the cyclical risk and potential for rapid declines in value. Research is key for investors.

4 Risks of Services Sector ETFs You Should Know

Variance in ETF Expense Ratios

The obvious metric that comes to mind when focusing on the benefits of investing in services sector ETFs is the performance rate. This line of thought is also sound – after all, the goal of any investor is to achieve the highest return possible.

It is worth noting that the Variability of Expense Ratios affects this performance rate to a considerable extent. Expense ratios are expressed as a percentage of the fund’s total assets on an annual basis and pay the operational costs of the fund in question, which include management, administration, and marketing . It is paramount to note that the vast majority of deserving services sector ETFs boast very low expense ratios.

However, it is also notable that this rate can differ by more than 40 basis points or half a percentage point between funds in the same sector . Thus, if the management style or the complexity of the fund leads to an expense ratio of 0.50%, which may be the upper boundary for the services sector as a whole, using a fund with a ratio of 0.10% will save significant money for the investor. In other words, lower expense ratios save the investor money, leading to higher net returns, especially for larger portfolios.

There are many historical examples of companies that had higher expense ratios and underperformed their benchmark peers in times of high market volatility or economic downturns, such as the 2008 financial crisis. The crisis ruined many companies, and every 1% of costs saved was like a lifeline that some surviving services sector ETFs managed to grab.

The precise differences can only be accurately discussed through examples. As such, take two services sector ETFs, with one having an expense ratio of 0.10% and the other having 0.50%, and invest $10,000 in both over 20-year periods with an annual compounded rate of return of 8%. The difference in returns due to the expenses, assuming fees grow with the investment, would amount to around $4,290. As such, a famous quote form the Vanguard’s excitement during this period of its history: “The miracle of compounding returns is overwhelmed by the tyranny of compounding costs!

Differences in ETF Mandates

An essential factor impacting the risk exposure and performance opportunities of services sector ETFs is Scope and Specificity of the ETF Mandate. As an outline of objectives, investment measures, and modes of operation, the mandate can greatly diversify, with the fund including different types of securities and following a different geographic focus, including the risk tolerance of the fund .

Specifically, one services sector ETF may be focused solely on the U.S. markets, with large-cap consumer service companies included in the fund. Another ETF fund can include large-cap and small to mid-sized financial service firm in both U.S. and other world markets. An ETF of the third kind can be focused solely on international investments, including only small to mid-sized American-oriented companies in various sectors like consumer services and materials. Under the above conditions, it is clear that the performance opportunities of an ETF may also greatly differ, especially in different economic cycles.

How Different ETF Mandates Responded to Different Phases of the Economic Cycle . A common argument to be considered is that, while the world markets were accelerating in the global economic expansion of 2000-2008, ETF funds with international mandate outperformed the domestically focused ETF services due to rapid rates of growth in the emerging markets . The opposite with the 2008 global financial crisis, as domestically focused ETFs were more stable, with global markets hit substantially. Findings can be presented as follows.

During the period of recovery from 2009 to 2012, the ETF concerned with international consumer services must have had the returns of 15% annually. At the same time, the returns of a similar ETF with its focus on American markets and interests must have constituted 10%.

A quote by Great Warren saying, “Risk comes from not knowing what you are doing” is particularly relevant in the context of this paper. It is absolutely essential for all investors to assess the specifics of the ETF mandates to find the investment opportunity, which would be the most suitable to take into account their risk-taking capabilities and financial objectives.

Risks of Overseas Securities

With regards to services sector ETFs that contain overseas securities , Navigating the Complex Landscape of International Investing is clearly crucial. Such investment instruments allow investors to be exposed to international markets, which can be ripe for high growth.

However, they also present significantly higher risks of various kinds — including currency risk due to fluctuation in the exchange rate. As a result, a far higher degree of caution and care should be taken with such investment instruments as ETFs that are exposed to non-U.S. markets.

One of the relevant types of risk is currency risk. For example, when there is a euro-strong dollar exchange rate and a strong dollar causes euro income of Europe-based securities in the holding to be converted back into dollars, the returns from these companies may grow weaker. This is exactly what happened when the Eurozone crisis emerged in 2011 and the euro-crumbled against the dollar .

Similarly, the period from 2010 to 2015 was the five years of increased currency volatility, which was exacerbated by the global events such as the three quantitative easing programs. Consequently, for the aforementioned years, if the Services sector ETF had a 30% non-U.S. assets holding, then the variance in returns was additional 5% solely due to currency risk.

Hence, it is crucial to understand the additional risks posed by investment instruments that invest in overseas securities. In addition, applicable to this situation is the quote of Benjamin Graham: “The individual investor should act consistently as an investor and not as a speculator” .

Potential for Leveraged Exposure

Understanding Leveraged ETF Dynamics is critical for investors considering services sector ETFs hiding the potential for multiple exposures. Leveraged ETFs use some kinds of financial derivatives and debt to increase the product of exposure, which is always some index. On one hand, they can raise potential profits to be made from market booms, but, on the other hand, they equally amplify stakes for any downturns. This results in a corresponding upward or downward impact on losses.

To illustrate at grab some hypothetical services sector based leveraged ETF. It has the objective of delivering two times the daily result of its parent index. Then, if this index grows by 1% in a day, the ETF is supposed to be growing by 2 %. If, however, in the next day the index drops by 1%, the loss on the ETF will be 2%, amplified by volatility. This seesawing dynamic, which is especially acute in the deep recess of economic slumps, can ruin capital if not prevented properly.

Put Another Way, a quarter of a month of market volatility in 2020 is illustrated below:

  • The leveraged ETF could have gone either +30% or -30% in less than a month

  • The non-leveraged sister is exposed to +/- 15%

The conclusion is that leveraged ETFs and corresponding investment strategies can be exceedingly risky. As there is a fundamental rule of Leveraged Exposure: The Less is Better. Especially for the highly volatile financial instruments and ETFs like the aforementioned Leveraged ETFs can wipe out vast sums quickly.

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