Lesson 6: Risks of Investing in ETFs

In the previous class, we learned two common investment strategies for ETFs: pyramid trading and grid trading;

However, if you want to make long-term profits in the stock market, it is more important to pay attention to risk than return. In this lesson, we’ll talk about the investment risks of ETFs.

1. Market Risk

（1）The risk of buying high

Compared with individual stocks, stock ETFs diversify your investment, but the trend of stock ETFs is still the same as that of the stock market.

This means that even if an ETF is bought when the market is up, it is likely to suffer losses over the long term, and even if the ETF is not as volatile as individual stocks, it could face a drop of 50% or even more.

For example, in March 2022, the Nasdaq 100ETF (QQQ) was purchased at a high level. Eight months later, the NAV of the ETF had fallen from 371 to 260, a drop of 28.62%.

So, even though ETFs have helped us avoid some risks through their properties, buying at high levels is still one of the risks that most people are most likely to lose money on.

(The Nasdaq 100ETF(QQQ) from March to November 2022)

（2）Risk of volatility

Here, we are mainly talking about stock ETFs. Stock ETFs invest in a basket of stocks. If those stocks rise and fall, the ETF’s value will fluctuate. As long as there are fluctuations, the account will have paper losses. Therefore, when investing in ETFs, no matter what strategy you use, you must be prepared to carry short-term paper losses.

Take the Nasdaq 100 ETF (QQQ) as an example. If QQQ was bought on March 29, 2022 and held until August 15, although the ETF itself fell by only 8.73%, the amplitude reached 28%.

This means that the maximum decline from the highest point to the lowest point during that period was 28%. In the process, many investors left the market because of panic or stop losses, taking a loss of far more than 8.73%.

(Schematic diagram of the NASDAQ 100ETFQQQ amplitude from March to August 2022)

Market volatility will always exist, so we need to face it properly and make ETF choices well in advance.

2. Risks of industry ETFs

(1) Additional industry risks

If you choose a sector-specific ETF, in addition to bearing the systematicrisk of each stock within the basket, you also have to bear the risk of the industry itself.

This industry risk manifests itself asups and downs outside of the index, sometimes marked by dramatic declines.

For example, compare the performance of the S&P 500 (SPY), financial ETF (XLF) and consumer discretionary ETF (XLY) from early 2022 to November.

We find that while the three indices have generally converged, their returns have been vastly different. The S&P 500 (the blue line in the figure) fell 21.56% from the beginning of the year to November.

During the same time period, the financial ETF (the yellow line in the figure) fell 13.09%, and the consumer discretionary ETF (the purple line in the figure) fell 35.67%.

Therefore, when choosing an industry ETF, investors have to have a strong understanding of relevant information, such as industry trends. After all, depending on the industry you choose, the difference in returns willdiffer greatly.

(2) It's hard to choose the best

There are always a few companies withanoutstanding investment value inan industry sector because many companies within that industry are already competing with each other.

In some mature industries, there are usually two or three leaders, and most of the others are either mediocre companies or those with poor performance.

For industry-themed ETFs, in order to diversify risk, fund managers will allocate funds to a variety of stocks within the industry.

In this way, they are necessarily forced to buy shares in companies of ordinary quality, resulting in wasted positions and dragging down the overall performance of the ETF.

3. Tracking Error Risk

First, let's talk about what tracking error is.

ETFs incur a variety of fees and costs when constructing and operating a portfolio, eroding the fund's returns;

There is no human interference or operating costs or expenses associated with the construction of an index, which makes for a large difference between the return on an ETF and the return on an index.

This difference is called “tracking error.”

There are many factors that affect ETF tracking error, mainly caused by the following :

(1) Liquidity

The primary factor influencing a tracking error is stock liquidity. When ETFs construct investment portfolios and adjust the constituent stocks and their weights, it impacts stock prices, causing the portfolio to deviate from the index.

The better the liquidity of the constituent stocks, the smaller the impact of the ETF on stock prices during portfolio fitting, and the smaller the tracking error. Conversely, the larger the tracking error.

(2) Transaction costs

When an ETF constructs a portfolio based on the constituent stocks of an index, it needs to pay fees such as transaction commissions and stamp duties, among others.

In addition, transaction costs also include management and custodial fees. The existence of transaction costs makesa tracking error inevitable.

(3) Subscription and redemption of ETFs.

The subscription and redemption of ETFs, especially large subscriptions and redemptions, will have a great impact on the investment portfolio. It will increase the fund's transaction costs and market shock costs and expand the tracking error with the underlying index.

(4) Changes in constituent stocks. An index frequently changes its constituent stocks, and every change forces the ETF portfolio to adjust accordingly, which affects the stability of the portfolio as well as market performance, and increases transaction costs and market shock costs. Tracking errors are inevitable.

Therefore, investors must pay special attention to trackingerrors when choosing an index ETF. The smaller the tracking error,the better the fit of the ETF with the index.

4. Liquidation risk of ETFs

ETFs may close because of low investor interest or a lack of investment funds or, in line with the fund's liquidation procedures, when the ETF's issuer believes the ETF is unprofitable. In the best interests of shareholders, ETFs are at risk of being liquidated.

If the ETF has already made a good return at the time of liquidation, the liquidation is equivalent to profit-taking for investors and will not have much negative impact. On the contrary, if the ETF is in a loss, liquidation at this time is equivalent to turning the paper loss into a real loss, and investors will also lose liquidity for a period of time.

5. Risks of leveraged ETFs

(1) Higher transaction costs

Leveraged ETFs can help you leverage larger profits with a small amount of money, but this is a double-edged sword. Due to leverage, while the gain is doubled on a profit, the loss is also doubled on a loss.

In addition, leveraged ETFs have higher transaction costs, such as: in addition to higher management fees and higher transaction costs, leverage also requires payment of interest and faces counterparty risk, because many leveraged ETFs are “Over-the-Counter” (OTC) derivatives signed with major investment banks. If the investment bank fails, theoretically, the value of this derivative will be zero.

(2) Risk of loss

For example: when investing in an ordinary ETF, suppose the NAV of the fund is100 on the first day and it rises to 110 (+10%) on the next day.

On the third day, it falls back to 100 (-9.1%), and the NAV of the ETF returns to its original point. These three daysresult in no loss and no profit.

If you invest in a 2x leveraged ETF, the same volatility will cause the fund's NAV to first rise to 120, and then fall to 98.16, which is equivalent to a loss of 1.84%.

So, the asset value of a leveraged ETF can be continuously depleted due to volatility.

The longer the position is held, the greater the risk of leverage depletion. Therefore, leveraged ETFs are generally used for short-term investments to take advantage of periodic opportunities.

6. Risks of frequent trading

ETF trading can be as efficient and convenient as that of stocks, and the risk is relatively low. Therefore, many investors ignore the transaction costs of ETFs and trade frequently. Between buying and selling, the transaction costs of ETFs can consume a lot of profit, resulting in low total returns for investors.

7. Liquidity Risk of ETFs

Liquidity risk refers to whether it is easy to buy and sell in the market for cash without damaging the value of the ETF. Investing in ETFs with lower liquidity can lead to higher transaction costs or more difficulty selling.

To avoid the liquidity risk of ETFs, we can focus on the following data:

(1) The bid-ask spread refers to the spread between the bid and ask price of an ETF; generally, the narrower the bid-ask spread, the more liquid the ETF.

(2) Average trading volume. The higher the volume, the higher the liquidity of the ETF.

(3) Whether the transaction price of the ETF is close to its Net Asset Value (NAV) price, if the price of the two is closer, it means that the liquidity of the ETF is higher.

The above are the main risks that should be paid attention to and screened for when trading ETFs. Of course, it is almost impossible to completely eliminate the investment risks of ETFs. In addition to understanding risks of pitfalls in advance, investors can also reduce risks in a variety of other ways.

For example, diversification is a very effective way. By spreading funds across different industries, regions, and asset classes, even if a single ETF is at risk, other assets can balance potential losses.

Well, that's it for today. By understanding these seven risks, you can avoid many common trading mistakes!

In the next lesson,I’ll give you some useful practical knowledge: how to trade ETFs on the Tiger Trade app.

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Disclaimer-NZ

This course is made for educational purpose only. It is neither financial advice nor recommendation on buying or disposing financial products.Stock investments carry risk, stock market can be volatile and risky, including risk of losing an amount in excess of your initial investment. Short selling is risky and not suitable for all investors. This course does not consider your investment goal or objective, Tiger Brokers assumes no warranty or responsibility for the accuracy and completeness of the information. Past performance is not an indicator of future performance. Please read our risk disclosures and you may need to do your own research or seek professional advice before using the services of Tiger Brokers and making investment decisions. please visit https://www.tigerbrokers.nz/ for more information.