ETF Risks And Portfolio Applications

Risks of investing in an ETF include the following:

• Counterparty risk. Some ETF legal structures expose the investors to counterparty risk. Exchange traded notes (ETNs), for example, have high counterparty risk.
• In the case of an ETN, an issuer (typically a bank) issues unsecured debt obligations that promise to pay the return on an index less management fees (just like a regular ETF). Consider, for example, a large bank that wants to issue unsecured debt at a fixed interest rate. If the fixed interest rate that the market demands is significantly higher than the swap fixed rate for same maturity, the bank may instead issue an ETN that pays the return on an equity index.
• The bank then would simultaneously enter into an equity swap as the equity return receiver and the (swap) fixed rate payer. The index return received is used to service the ETF, and the bank’s effective borrowing cost becomes the swap fixed rate (we will assume that the ETN management fees cover the actual cost of the structure).
• The concern here is that the bank may default, resulting in losses for the ETN investor (e.g., Lehman Brothers defaulted on three ETNs in 2008). Investors can estimate the counterparty credit risk by the credit default spreads (CDS spread) of the issuing bank: large CDS spreads indicate high counterparty risk. In general, a one- year CDS spread above 5% is considered to be very risky.
• Settlement risk. ETFs using OTC derivative contracts as part of their strategy expose investors to the settlement risk of such contracts. ETFs mitigate settlement risk by frequent (e.g., daily or weekly) settlement, and/or by requiring collateral to be posted.
• Security lending. Like mutual funds, ETFs may lend their securities to short sellers for a fee. These lending agreements are overcollateralized, and the collateral is invested in short term risk free securities.
• Lending fees are often lucrative and are usually passed on to the ETF investors, offsetting the fund’s operating expenses. The (rather insignificant) risk of the security borrower defaulting is, however, borne by the ETF investors.
• Fund closures. Similar to mutual fund closures, ETF closures involve selling the underlying holdings and making cash distributions to the investors, potentially with adverse tax consequences for them. Soft closures entail creation halts and changes in investment strategy.
• Closures may be triggered by changes in regulation, competitive pressures, or issuer merger. Increased competition may force ETFs that fail to attract sufficient capital to close prematurely. In addition to fund closures, investors may also be exposed to the risk of creation/redemption halts.
• Particular to ETNs, this risk arises when the issuer is no longer interested in additional borrowings. When creations are halted, ETNs may trade at a significant premium to their NAV as the arbitrage mechanism breaks down.
• Another reason for fund closure is that the issuer may want to change investment strategy. This results in closing down of the fund tracking the original strategy and opening of a new fund tracking a different strategy. This is rather uncommon, as, more typically, issuers make minor changes in investment strategy, requiring small adjustments to portfolio composition rather than fund closure.
• Expectation related risk. ETFs based on complex strategies (e.g., inverse or leveraged ETFs) may introduce the investor to risks that they may not fully comprehend (i.e., the outcomes may differ from investors’ expectations). These complex ETFs might use derivative products to implement their investment strategy that must reset daily (i.e., have daily settlement).
• For example, an ETF with NAV of $100 delivering two times the S&P 500 return would enter into a swap with a notional twice the NAV of the ETF (reset daily). Suppose that the daily return is +5% on the first day, and −5% on the next day. The NAV would grow to 100 + (2 × 5%) = $110 on the first day.
• On the second day, the NAV would decline by 10% or 110 × (1 − 0.10) = $99. A less sophisticated investor might expect the NAV to finish unchanged by these offsetting returns.
• The compounding effects of leveraged ETFs make them unsuitable for buy and hold investors with investment horizons exceeding one month.

Due to their low costs, tax efficiency, and wide variety, ETFs are suitable for numerous portfolio strategies. Some of them are described in the following.

1. Efficient portfolio management, including the following: a. Portfolio liquidity management: Managers can quickly equitize excess cash by

investing it in ETFs, in order to reduce cash drag on the portfolio. Because of their superior liquidity, ETFs have a lower transaction cost as compared to other securities; portfolio allocations to ETFs can be used to cover future cash outflows.

b. Portfolio rebalancing: ETFs can be used to cost effectively rebalance portfolios to

target specific asset class weights. ETFs can also be shorted to quickly reduce the weight of a specific sector or asset class.

c. Portfolio completion: ETFs can be used to fill temporary gaps in portfolio

allocation. Gaps can arise due to manager turnover (when the new manager has different macro views) or when the existing manager’s allocation differs from the investor’s desired exposure. Suppose for example that a manager moves out of small caps; an investor seeking continued exposure to small caps can invest a portion of her portfolio in a small cap ETF.

Similarly, investors in an actively managed fund could use ETFs to adjust overall exposure to suit their individual preferences.

d. Transition management: A new manager might temporarily invest in ETFs as she

winds down the portfolio allocations of the old manager, so as to maintain market exposure during the transition period.

It should be noted that ETFs may not be suitable for very large asset owners: separately managed accounts (SMAs) may be able to operate at a cost even lower than the ETF fees. Furthermore, SMAs can be customized (as opposed to the rigid allocations of ETFs). Finally, regulators often require public disclosure of large ETF holdings, which SMAs may not want to do.

1. Asset class exposure management. The wide variety of ETFs, including asset class, subclass, and sector, allow a manager to implement a variety of strategies suitable for their clients.

Often, ETFs provide significant cost advantages relative to investing in the underlying securities. For example, it is easier to trade fixed income ETFs versus the underlying bonds (which tend to be relatively illiquid). Strategies include the following:

a. Core exposure to an asset class or sub asset class: Portfolio allocations to passive

indices of various asset classes/subclasses can be cost effectively implemented using ETFs. Portfolios can be broadly diversified by investing in different sectors of equity asset class, commodities, bonds, etc. Targeted strategic allocation to a specific subsector can also be implemented for an investor based on suitability (e.g., an investor seeking exposure to precious metals). b. Tactical strategies: Managers can temporarily rotate money into/out of sectors

expected to perform better/worse using ETFs. Thematic ETFs can also be used to select subsectors (e.g., ecommerce versus the broad technology sector) that are expected to outperform. ETFs selected for short term tactical strategies are selected based on lower trading cost and liquidity rather than low management fees.

(Liquidity is evaluated using the ratio of average dollar volume to average assets, higher is better). 3. Active investing. While ETFs have historically been used for passive allocation to asset classes, newer varieties of ETFs with an active component have gained traction, especially for fixed income.

These ETFs are constructed based on predefined rules rather than manager discretion. Smart beta ETFs, for example, may use quantitative screens or use weights based on company fundamentals (e.g., dividend yield).

a. Factor (smart beta) ETFs: Benchmarked to an index that is created with

predefined rules (e.g., with screens and weightings). The ETF strategy is based on return drivers (i.e., factors such as size and momentum). Within a single factor, competing ETF managers’ offerings may differ based on the factor chosen or the weights assigned to portfolio holdings (e.g., equal weighted versus cap weighted).

Long term buy and hold investors seeking a desired factor exposure may choose to invest in these ETFs in the expectation of outperformance of those factors. Multifactor ETFs provide exposure to several factors and can dynamically change portfolio weights based on market opportunities. Performance of these ETFs depends on whether the ETF (via its rules) was successful in gaining exposure to that factor, and whether the chosen exposure was rewarded by the market. b.

Risk management: Some ETFs are constructed to provide higher or lower risk

relative to a passive index. Low volatility ETFs, for example, use rules to construct portfolios with low relative return volatility. Some ETFs may be constructed to hedge specific risks; currency hedged global equity ETFs provide international equity exposure but without the added currency risk.

Similarly, duration risk- hedged high yield corporate bond ETFs only provide exposure to credit risk while hedging the interest rate risk. c. Alternatively weighted ETFs: Constructed using portfolio weights that differ from

standard market cap weights (e.g., equally weighted, weightings based on fundamentals). d. Discretionary active ETFs: Actively managed and are similar to closed end mutual

funds. The largest of these are fixed income ETFs, which include exposures to senior bank loans, mortgage securities, and floating rate notes. e. Dynamic asset allocation and multi asset strategies: Dynamic top down asset

allocation ETFs that invest in stocks and bonds based on risk/return forecasts. These are popular among global asset managers and hedge funds for their discretionary asset allocation.

With a wide variety of “alternative” ETFs available, investors should perform due diligence regarding index construction methodology and performance history to determine suitability.