The popularity of Exchange Traded Funds (ETFs) investment has surged in recent years – but do investors really understand the risks?
An ETF, or Exchange Traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. (Source: Investopedia)
However, unlike mutual funds, an ETF trades like a common stock on a stock exchange and experience price changes daily.
Why have ETF investments become increasingly popular over recent years?
ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors. Why? Well, to start with, ETFs are typically associate with inexpensive fees and a wide range of investment options … what’s not to like?
Unfortunately, as with most things, when it’s too good to be true it usually is.
What are the risks associated with ETFs?
Typically, ETFs are legally restricted from investing above specific ownership thresholds in a stock. The ETF universe is large and growing. Unfortunately, a single ETF frequently has overlapping ownership positions vis-a-vis other ETFs. Consequently, ETFs now represent a substantial combined ownership position in most large capitalization companies.
Mutual funds and large (institutional) pension funds also hold many of these same companies in their portfolios.
Should a market correction happen, ETFs and institutional funds (which typically track the index) will aggressively sell shares. And we all know that more supply drives share prices lower.
When the ETF universe sells en masse, prices can fall dramatically for individual securities and for an entire index.
The 2008 Global Financial Crisis and the 2010 NYSE Flash Crash are two examples of the risks of hyper concentrated ETF ownership.