The RISKS of Investing in ETFs (Exchange Traded Funds)

The RISKS of Investing in ETFs

October 29, 2018

Investing can be hard. It takes A LOT of time to pick the right stocks, buy them at the right time, and have the confidence that they will do well. But what if you could relieve yourself of a lot of that stress? A professionally managed portfolio is for you! Two of the most popular ways to have your investments managed are through Mutual Funds or ETFs (Exchange Traded Funds: we will focus on this one today). First, lets run through what these things are, then we will talk about the risks associated with ETFs specifically.

Overview of ETFs

Imagine being an investor, sitting at home and trying to figure out the best way to invest in the stock market. (THIS MIGHT BE YOU LITERALLY RIGHT NOW) You will come to realize that it takes time to research and understand every single stock you are interested in.

Instead of doing this yourself, you decide to hire a professional investment manager to invest for you. You decide the best way to do this is through buying an ETF. ETFs are shares traded on the stock market that represent ownership in a basket of other things. The basket can be filled with stocks, bonds, commodities, real estate, foreign exchange, or a combination of all of these. What the ETF's basket holds is the most important part for YOU. As an investor in stocks, you would want to buy a stock market ETF. (One great example is Vanguard's Total Stock Market ETF: Ticker "VTI")

In order to keep records on how much you have invested, you will receive shares in exchange for your money. Each share of the ETF may cost a few hundred dollars. The price per share will fluctuate as the value of ALL the securities in the basket fluctuate. (If one stock in the basket is down in price, and the other ones are all up, the overall price of the ETF will appreciate, and vice-versa)

So technically speaking, an ETF is a "pooled investment vehicle". It will offer investors exposure to a particular area of the financial markets. You buy shares, which represent a proportional interest in the underlying pooled assets.

One cool thing about ETFs is, as an exchange-traded fund, you buy shares in an ETF directly from any regular brokerage account. Just like you would trade shares in a stock, you can enter a buy/sell order in your E-Trade or Robinhood account for an ETF. You can also do it aslong as the market is open. (Orders to buy or sell a traditional mutual fund are filled once per day after the close of trading, offering much less visibility into the price of buying into the fund)

Now we know that ETFs offer us the ability to invest in a specific portion of the financial markets at any time of day, all managed by a professional management company. ETFs will provide you with lower costs and more convenience. But this does not come risk-free, there are a few key risks associated with investing in ETFs. Here are my top 3:

1) Systematic Risk

Systematic risk is exactly what it sounds like: when the entire system poses a risk to your investments. This is when the market as a whole crumbles. This risk is inherent in any investment, but should be mentioned here first because it is the most major risk to ETFs. Just because you buy a highly diversified total stock market ETF like Vanguards VTI or VOO, it does not mean you are safe from systematic risk. There is virtually no way to diversify it out of existence. The only way to mitigate systematic risk is to be out of the system totally, this is called "market timing" and is very difficult to do.

Remember, the market goes both up AND down, so you need to be willing to hold through the good times and the bad! The market giveth and the market may taketh away.

2) Scam Risk

Where there are legitimate investment opportunities, there will also be scammers. The ETF market is no exception. There have been some incredible innovations in this space, but there have also been some absolutely horrible ideas with astronomical fees and no real viability.

Just because an ETF is on the market today DOES NOT mean that it will be there forever. So stay away from the no-name managers and invest in ETFs curated by the largest names in the money management business: Vanguard, Fidelity, Blackrock (iShares), etc. These names will provide you with the comfort of knowing that they are much less likely to be shut down than the "INVESTOBOi 9000 YOLO Market ETF FOR MILLENNIALS". A good way to check if an ETF is at risk is to go to ETF.com and search for the ETF you are interested in investing in. Then click on the "Efficiency" tab. On the right hand side of the page there should be a label named "Fund Closure Risk" or something along those lines. If it says "Low", you are good to go!

In addition to the fund closure risk, take a glance at the expense ratio of the fund. The best, most efficient funds are run at an expense ratio of .1% (NOT 1%. 1/10 of 1%!) or less. Anything higher than that should be looked at with caution. The Vanguard funds I recommend cost about .04% in fees every year, and will be deducted automatically from the price of the ETF. So you do not have to worry about any cash actually being withdrawn from your account.

3) Liquidity Risk

This one is a doozy. Liquidity = The ability to turn your asset (in this case, an ETF, but it can be anything) into cash. By buying an ETF, you are basically purchasing a basket of some underlying securities ALONG WITH their liquidity. For example, if you buy an ETF that holds real estate, those underlying positions would be LESS liquid than publicly traded stocks. (It is easier to buy and sell stocks than it is to transact physical real estate)

It is safe to say that ETFs trading large cap stocks, like Vanguard's VTI or VOO, will be quite liquid even during the most extreme downturn. But a more obscure ETF trading Mortgage Securities may be much less liquid in times of distress, resulting in poor trade execution for you, the end buyer of the basket. This is not good, and liquidity lockup should be a major concern for anyone investing in anything. It is critical to be able to turn your investments into cash easily and for a low cost.

In Conclusion...

Buy into funds that invest in liquid assets, are managed by highly regarded professionals, and are not at risk of being closed. Once you find something that meets all of those criteria: Start Investing and Keep Investing (Through thick and thin!)

If you are interested in reading more about the Vanguard funds I mentioned, check out The Difference Between the VTI and VOO ETFs (CLICK HERE).

Thank me later.

MDAS

If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!

P.S. New blog posts coming your way every Monday!

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