Open book presenting 5 major risks associated with ETFs

ETFs (Exchange Traded Funds) are investment funds traded on stock exchanges, similar to individual shares, designed to track the performance of a specific index, sector, commodity or basket of assets. 12. As instruments that allow investors to buy and sell throughout the trading day at fluctuating prices, they offer intraday trading opportunities and can be a cost-effective way of gaining exposure to a diversified portfolio. 2.

However, these instruments are not without risk: they are subject to market fluctuations and may experience liquidity problems, especially in volatile market conditions. 2. Our company, de Ravel Finance, is ready to assist those looking to invest in ETFs, offering guidance and expertise in navigating the stock market investment landscape. 23.

1. Liquidity risk

The liquidity of ETFs is often greater than investors imagine, being determined by the liquidity of its underlying assets rather than the size of its assets or trading volumes. 4. This means that :

  • The unique ETF ecosystem ETFs: Unlike other traded instruments, ETFs operate in a distinct ecosystem with capital variation and the ability to issue or redeem shares according to investor demand. 4.
  • Evaluating the liquidity of ETFs Investors should look beyond trading volumes and fund size to assess the liquidity of ETFs, considering the total liquidity of ETFs on secondary and primary markets. 4.
  • Using limit orders Investors are advised to use limit orders when trading ETFs to control the price of the transaction, thus avoiding prices that are significantly different from those expected. 4.

At de Ravel Finance, we recommend that investors work closely with their ETF providers, especially during difficult times that can lead to wider spreads and less efficient trading. 4. Our professionals are here to help you navigate these complex aspects of financial investment.

2. Market risk

Market risk in ETFs is a crucial factor for investors to consider. This risk manifests itself in several ways:

  1. Fluctuation in ValuesThe value of the underlying assets of ETFs may fluctuate, resulting in potential financial risk for investors. These fluctuations are due to changes in market conditions which may adversely affect the performance of the ETFs. 8.
  2. Concentration and Volatility:
    • The concentration of investments in certain sectors or countries increases the risk linked to specific market movements 9.
    • The volatility of ETFs, measured by fluctuations in their value, indicates increased risk. ETFs with high volatility are considered riskier 9.
  3. Risks Specific to Types of ETFs:
    • Synthetic ETFs, which use derivatives to replicate the performance of an index, introduce additional risks associated with the use of these financial instruments. 9.
    • Securities lending by ETF managers can also involve risks if the borrower defaults. 9.
    • Leveraged ETFs amplify changes in the underlying index, making them more suitable for experienced investors because of their increased risk. 10.

3. Risk of issuer bankruptcy

In the context of an ETF issuer bankruptcy, it is crucial to understand the protections in place for investors:

  1. Secure Property ETFs are considered internal collective investment portfolios under Swiss law, and in the event of the insolvency of the issuer or custodian bank, the ETFs remain the property of the investor. 3. This means that the underlying assets are protected and separated from the issuer's balance sheet, minimising risk for the investor.
  2. Limited counterparty risk :
    • In the case of synthetically replicated ETFs, counterparty risks are limited 3.
    • If the ETF issuer goes bankrupt, another company can take over management of the ETF, especially if it is profitable. 12.
    • There may be a temporary halt to ETF trading, but ownership of the ETF shares or the money from the sale of the underlying assets may be recovered. 12.
  3. Legal Protection and Prevention The ETF is a legal entity separate from its provider, and the ETF's assets are held by a custodian, reducing the risk of loss due to the provider's insolvency. 6. To date, there have been no known bankruptcies of ETF issuers, which underlines the robustness of these structures in terms of investor protection. 12.

4. Foreign exchange risk

Currency risk is a major concern for ETF investors, especially when investing in assets denominated in foreign currencies. Here's how euro ETFs can help manage this risk:

  • ETFs in euros for currency hedging:
    1. Offers protection against exchange rate fluctuations 13.
    2. This is followed by the value of the euro against other currencies, allowing exposure to the euro without holding the currency itself 13.
  • Advantages of euro-denominated ETFs:
    • Liquidity, lower management fees and greater transparency than funds actively managed in other currencies 13.
    • Allows investments to be diversified into different currencies, reducing exchange rate risk 13.
  • Managing currency risk with ETFs:
    • Euro ETFs are not the only strategy for managing currency risk, but they are a useful tool for investors seeking to mitigate exposure to exchange rate fluctuations. 13.
    • Investing in globally diversified ETFs means investing in countries and companies outside the eurozone, thereby diversifying the risks and opportunities associated with currency changes. 14.

5. Index replication risk

Index replication risk in ETFs is a major concern for investors. Here is a detailed exploration of the different replication methods and their implications:

  1. Direct Replication This method implies that the ETF holds all the securities in the index in the same proportion as the index. 6.
    • Advantage: Minimises tracking error 8.
    • Disadvantage: Can be difficult to manage for indices with a large number of stocks.
  2. Sampled/Optimised Replication The ETF holds a selection of securities from the index, with the aim of approximating the performance of the index. 6.
    • Advantage: More flexible and less costly to manage.
    • Disadvantage: May lead to greater tracking error 8.
  3. Synthetic replication :
    • Principle The ETF holds assets not linked to the index and enters into a swap agreement with a counterparty to replicate the performance of the index. 6.
    • Types of ETF swaps Unfinanced swaps, financed swaps and fully financed swaps, each offering different levels of risk and protection for investors. 17.
    • Benefits Generally, a lower tracking error, a lower total expense ratio and the ability to replicate hard-to-reach indices. 17.
    • Disadvantages Additional risk of counterparty default and potential lack of transparency 17. Possible conflict of interest when the swap is concluded with the ETF provider's parent company 6.

Conclusion

At the end of this review of the major risks associated with ETFs, it is clear that although these instruments offer diversified opportunities for investors seeking to track the performance of various indices, sectors or baskets of assets, they are not without their challenges. Liquidity risk, market risk, issuer bankruptcy risk, currency risk and index replication risk all require careful consideration and analysis to avoid potential pitfalls.

By recognising these risks and preparing adequately for them, investors can make informed decisions designed to enhance their investment potential and minimise losses. We encourage readers not to navigate these sometimes turbulent waters alone. If you would like support with your investments, please do not hesitate to contact our Ravel Finance team to discuss the solutions we can offer you. Our expertise and guidance could be the key to successfully navigating the complex world of ETFs, strategically aligning your investment choices with your long-term financial goals.

FAQs

What are the dangers of investing in ETFs? Investing in an ETF mainly involves the risk of fluctuations in the market index it replicates. If the index falls, the value of your investment will fall proportionately, and this fall may be even greater if you have chosen a leveraged ETF.

Why should I consider investing in ETFs? ETFs are advantageous because they offer a wide range of investment options for diversifying your portfolio. They give you access to a varied range of securities, whether French or international, representing a specific market, sector or investment strategy.

What do ETF assets under management mean? The AUM of an ETF represents the total amount invested by all investors in that fund. A high AUM means that the ETF is well established and reduces the risk of it being withdrawn from the market.

Can ETFs include leverage? Yes, certain types of ETF, as undertakings for collective investment (UCIs), can use leverage. ETFs can replicate the benchmark index physically, i.e. by buying and managing the same securities as those in the index.

References

[1] – https://www.amf-france.org/fr/espace-epargnants/comprendre-les-produits-financiers/placements-collectifs/trackers-etf
[2] – https://www.amf-france.org/fr/actualites-publications/communiques/communiques-de-lamf/etf-et-risques-associes-lamf-apporte-un-eclairage-sur-le-marche-francais-des-fonds-indiciels-cotes
[3] – https://www.vermoegenszentrum.ch/fr/competences/epargner-et-investir-avec-des-etf-questions-et-reponses
[4] – https://am.jpmorgan.com/fr/fr/asset-management/per/insights/etf-perspectives/true-etf-liquidity/
[5] – https://www.investopedia.com/articles/exchangetradedfunds/08/etf-liquidity.asp
[6] – https://www.epargnant30.fr/etf-replication-physique-synthetique-risques/
[7] – https://www.cairn.info/revue-d-economie-financiere-2013-1-page-85.htm
[8] – https://www.blackrock.com/be/individual/fr/education/explication-des-etf
[9] – https://www.vaneck.com/fr/fr/risques-etf/
[10] – https://www.capital.fr/entreprises-marches/etf-1338566
[11] – https://curvo.eu/fr/article/etf-risque
[12] – https://twitter.com/Argent_Qui_Dort/status/1681345979587469312
[13] – https://www.reddit.com/r/vosfinances/comments/18mxczd/risque_de_change_sur_les_etf/
[14] – https://www.hellomonnaie.fr/guide-etf/risques-de-change/
[15] – https://am.jpmorgan.com/fr/fr/asset-management/per/funds/fixed-income/currency-hedged-share-classes/
[16] – https://www.morningstar.fr/fr/news/94407/que-faire-du-risque-de-change-.aspx
[17] – https://extraetf.com/fr/ressources/qu-est-ce-qu-un-etf-swap
[18] – https://www.ecb.europa.eu/press/financial-stability-publications/fsr/special/html/ecb.fsrart201811_3.en.html
[19] – https://www.trackinsight.com/fr/education/que-se-passe-etf-deliste
[20] – https://www.investopedia.com/articles/etfs-mutual-funds/061416/biggest-etf-risks.asp