Liquidity is the degree to which an asset can be quickly bought or sold without affecting the general stability of its price. ETFs are often considered inherently liquid due to their listed structure on major exchanges around the world.
It’s true, for the most part, but there are exceptions where liquidity becomes a concern for various reasons. These include large one-off trades that could impact market prices if done over a short period and small funds that don’t have enough accumulated assets needed to stay afloat or meet liquidity demands.
Market risk is the possibility that market conditions could harm an ETF’s value. It includes interest rates, exchange rates, and political instability, which can affect stock prices in general. Market risk can be heightened through large speculative trading in ETFs – mainly when they don’t track their respective index closely due to overestimated or underestimated net asset values (NAV).
Index tracking error
It is the difference between how an ETF performs versus its benchmark index over time. The lower this number, the better it generally means for investors holding this specific asset long term.
There are several reasons why this metric may skew to either end of the spectrum, including overly optimistic parameters used to track index, unfavourable market conditions and large one-time trades executed by the ETF’s issuer. Tracking errors may also occur due to underlying securities being bought or sold, harming returns over time.
Concentration risk is when a majority of an ETF’s assets are held in a small number of individual stocks, industries or sectors that may be out of favour with the general public — increasing volatility while decreasing liquidity due to lack of broad appeal.
Concentration risk has become more prevalent in recent years, especially amongst low-cost funds that track popular indices but invest in less than their benchmark constituents. For example, an S& P 500 fund only tracking 20% of its respective index constituents would be considered to be experiencing heavy concentration risk.
Country / sector exposure risk
Countries and sectors can directly influence an ETF’s total returns due to the relationship they share with the index that it claims to track. For example, if Country A has a high correlation to Sector B within their respective markets – it would stand to reason that in times of positive growth, both assets will perform in tandem.
When things take a turn for the worse, either in Country A or B, this can have negative implications against what was previously assumed – creating increased volatility within the fund. It’s another prevalent concern amongst low-cost commodity funds. You are investing in just one country rather than diversifying across multiple countries/regions, which could be a more practical solution for mitigating risk.
Emerging markets risk
Emerging market ETFs have become increasingly popular over the past decade, with investors seeking to benefit from expected growth within this region. As many countries in this part of the world lack consistent financial regulation, currency stability and overall transparency, it can be challenging for overseas investors to determine what kind of risk they are exposing themselves to – which is exacerbated when companies that aren’t even based in these regions are being included in their respective ETFs.
This problem became especially prevalent amongst commodity funds in 2011 when markets experienced an overwhelming amount of volatility due to internal conflict and political instability among various regions.
Interest rate risk
Interest rate risk is when an investment’s value is expected to decrease in a fluctuating interest rate environment. Bonds and bond funds, in particular, tend to be most at risk because of their sensitivity to changes in rates. Longer-dated bonds tend to experience the most significant impact when interest rates change – especially if they are already trading at a premium or discount without any movement in yield.
While this risk can be mitigated by keeping your portfolio well-diversified, it may still be worth noting that certain low-cost ETFs will not expose you to an excess amount of risk due to the high carry costs needed for short term holdings.