Tuesday 31 August 2010

ETF Risks - Which Matter, Which Don't, What to Do

Ever read the prospectus that must accompany every ETF by law and that is thus posted by every ETF provider on its website? The prospectus tells investors how the ETF is run and always includes a key section, often titled Risk Factors, which identifies the dangers the fund faces.

Since not all risks have the same importance (and since many investors' eyes probably glaze over if they ever open up a typical prospectus of 100+ pages) let's run through the various risks and attempt to pick out those that are both most likely to occur and most harmful. For each risk, we'll identify measures that the investor can take to mitigate the damage. It is obvious that the universal fail-safe anti-risk measure is simply not to buy ETFs at all, but keeping your money safe in cash or GICs will not produce much return either, especially when taxes and inflation are taken into account. To keep things simpler we'll focus on the most serious risks facing equity ETFs. Click on the two table images below for details of all the risks named in a typical ETF prospectus - red colour text highlights the worst risks, orange is medium and black text shows low risks.

General Equity Risks
These are risks that apply to equities in general and thus they apply to any ETF that holds stocks.
  1. Economic Conditions: The most dangerous of these harmful events are recessions, depressions and bursting market bubbles which can and regularly do destroy shareholder wealth on a scale ranging from discomfort to catastrophe. Since the economy has inevitable peaks and valleys, the harm is sure to occur. The only question is how severe the effects will be and how much the market will fall over how long a period before recovery takes hold. My Money Blog posted an informative table on this subject with US data titled Stock Performance During Recessions sourced from Fidelity Investments. An investor can cushion the blow, though not eliminate the fall entirely, by ensuring that his/her portfolio holds a good proportion of bonds. Diversification using a number of asset classes in a portfolio helps a lot. Our post The 2008 Crash - Case Study in Diversification showed how beneficial government bonds in particular proved to be. Investing for the long term to ride out the lows is another powerful tool for prospering despite severe downturns.
  2. Inflation and Rising / High Interest Rates: These two factors are often inter-related. Interest rates are made to rise deliberately by the central bank when a nation's economy gets over-heated or when inflation takes hold. Though inflation has been held in check at low rates for eighteen years now, there is no assurance that it cannot rise again to the persistent high levels of the 1970s, when stock market returns were very low for a decade. Periods of extreme out-of-control hyperinflation do the worst harm. For more, see Crossing Wall Street's How Does Inflation Impact Stock Prices and Investopedia's How Interest Rates Affect the Stock Market. The two best ways to counter inflation and interest rate risk are: include an allocation to real return bonds which automatically rise in value with CPI and, diversify amongst multiple countries, since not all countries experience high inflation/interest rates at the same time.

ETF-Specific Risks
These risks result from the way ETFs are built and operated. Most are minor but one is especially noteworthy and investors should consider it closely when selecting ETFs for their portfolio.
  1. Index Replication Error: This is a curious name for the fact that management fees, taxes and transaction costs incurred by ETFs unavoidably reduce return below that of the index each ETF aims to track, such as the TSX Composite. The higher the fees, the lower the investor's net return. The solution is thus to pick low cost ETFs within an asset class. That's why our previous posts comparing ETFs include this factor - USA S&P 500 or Similar Equity Index Funds, USA Total Market Equity, Emerging Market - US Traded and Canadian Traded, Canadian Large Cap Equity and Investing in China.

Canadian ETF Provider Prospectus Links

The fact that risks are inevitable with equity ETF investing does not mean that all risks and all ETFs are equal - some risks are worse than others, some ETFs are better than others and some strategies to control risk work better than others too. To recognize risk and take reasonable counter-measures is the mark of prudent investing.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


Anonymous said...

Hey there,

Long time reader, first time complainer ;)

Your new tiny font is making my eyes bleed...please consider it switching back.


CanadianInvestor said...

Anon, thanks for your note. Is it ok now?

Debt settlement program said...

Good post. While each of these risks might be considered a minor problem, they can add up to create sufficient risk to alter your final decision.