The biggest risk of ETFs is market risk. Like an investment fund or a fixed capital fund, ETFs are just an investment vehicle, a wrapper for your underlying investment. So, if you buy an S%26P 500 ETF and the S%26P 500 falls by 50%, nothing cheap, fiscally efficient or transparent an ETF is will help you. Market risk also belongs to the risk group of ETFs and refers to the risk of general price movements in a market, such as a stock market.
All stocks, bonds or ETFs are influenced by general market movements; if the entire market goes down or up, your investment may also react. Retail investors often underestimate concentration risk. This means that your portfolio's volatility will increase if you invest in just a few stocks. Even if you invest in several stocks, you may suffer significant concentration risk if these stocks come from a few sectors, countries, currencies, or investment styles.
Securities lending is another category of ETF risks that is often overlooked. Some ETF managers lend ETF stocks or bonds to other parties. These other parties could be hedge funds that speculate on the fall in the stock price. While securities lending generates benefits for you, the investor, there is also a small risk of loss if the borrowing party were to go bankrupt.
In some cases, splitting up loans is often more advantageous for the issuer. Jolien Brouwer talks about securities lending, a major risk factor for ETFs. Market conditions (for example, lack of liquidity in volatile markets) can make it difficult to buy or sell ETFs under certain circumstances. ETFs that use derivatives to reproduce an asset or index are subject to particular risks.
Some ETFs, for example, may use some types of off-exchange derivatives (OTC) that are not subject to central counterparty clearing agreements and are therefore more exposed to counterparty risk. ETFs may be susceptible to liquidity risk. Generally, your liquidity will be correlated with liquidity in the underlying asset market or asset basket, meaning that when the underlying market loses liquidity, the ETF product is likely to also lose liquidity. These types of ETPs usually use short selling or are built synthetically using OTC derivatives to obtain an inverse return.
This makes these products riskier than many other ETPs. Short selling, in particular, may involve the risk of incurring substantial losses that exceed the initial amount invested. OTC derivatives may be subject to significant counterparty risk. Leveraged ETPs generally involve the fund taking out loans to guide its exposure to investment or using OTC derivatives to obtain a specific return.
This leverage not only magnifies the potential gains and losses of investing in the ETP, but it also increases its volatility. Therefore, these types of ETPs are riskier than an equivalent product that does not provide leveraged exposure. An increase in the cost of ETP borrowing, which may be due to an increase in general interest rates or to an increase in the specific loan rate charged by the lender, is likely to reduce the product's profitability. Again, OTC derivatives may be subject to significant counterparty risk.
Synthetic ETPs use derivatives to achieve their investment objective. If you invest in them, you run the risk that the derivative counterparty will not fulfill some or all of its obligations. This risk is greater when the issuer uses OTC derivatives that are not subject to central counterparty clearing agreements. Usually, these types of ETPs have internal market creation agreements in which the ETP itself is responsible for providing liquidity in the ETP, and not an external market creator.
This creates potential conflicts and risks. Since the benefits of market creation go to the ETP, this creates an incentive for the ETP to expand the spreads in order to generate additional returns for the ETP. In turn, this means that investors may not be able to enter and exit the ETP at prices as close to the net asset value as those of other products. The problem is that many of these funds are, at best, useless fads designed primarily to charge fees from investors, not to satisfy a real need.
They are often potentially dangerous to the financial health of those who buy them and, in the worst case scenario, arguably to the health of financial markets in general. . .