What you need to know about the hidden risks of ETFs
In a rapidly evolving product landscape, exchange traded funds (ETFs) continue to hoover up assets at a rate of knots. While IG Smart Portfolios invest in straightforward ETFs which own their underlying securities and track well known asset classes, a host of acronyms — exchange traded commodity (ETC), exchange traded product (ETP) and exchange traded note (ETN) among them — have sprung up to badge listed products that track an index.
Not all of these products are intended to be held for the long term and many are designed for short—term trading. Sitting alongside traditional indices such as the FTSE 100 (read our Top 50 ETFs guide for more ideas), there are products investing in sectors, commodities, currency hedged allocations and smart beta, a type of product which offers your portfolio style tilts.
At the riskier end of the spectrum there are derivative—based issuances that offer exposure to volatility and leveraged vehicles that aim to enhance returns by using borrowing to go long or short, with up to three times exposure to equity indices.
A simple rule for investors is this: if you don’t understand the product, you probably shouldn’t buy it. Our view is that the ETF structure is no more risky than that of a fund (read more here), but the investment strategy and asset allocation of the ETF should be closely inspected before investing sizeable percentages of your money.
Not all ETFs will perform as you might hope
With complexity comes hidden risks — how many investors understand the impact of contango before making investments in commodity ETFs, or the erosive powers of daily resetting leverage when looking at a three times long FTSE 100 ETF, or even how to calculate volatility?
As you’ll see, it pays not to confuse trading products with investment products. Investors need to be wary of some of the more esoteric products and ensure they understand how to use them before buying.
ETF risk: commodity contango
While you can physically hold gold and silver bullion, ETFs that invest in most of the other commodities such as natural gas or oil do not hold the underlying commodity as it is too costly to store. Instead, they usually own a one month commodity futures contract and steadily roll the contract into the two month future as it comes up for expiry.
If the price of the two month future trades above the one month future’s price, you suffer a ‘negative roll yield’ from selling low and buying high. Someone owning the ETFs Brent crude ETC over three years (to 19 March 2018) has lost 15.2% of their investment, while the Brent crude spot price has risen by 21.4%.
Read more about investing in commodities
ETF risk: daily leverage
Leverage is another tricky area. Surely by owning a three times long ETF, you could make three times the return of the market? You can — but only over daily periods. To keep the product three times leveraged the product resets on a daily basis, effectively buying high and selling low which helps on the way up and hurts on the way down.
Math dictates that each time there is a directional change in the market, you will lose some value. On day one, if the index rose 10%, the three times leveraged fund would gain 30%. However on day two, if the index fell back to 100 (a loss of 9.09%), the three times leveraged fund would fall from 130 to 94.5, a loss over the two days of 5.5%.
Read our guide to leveraged ETFs
ETF risk: volatility products
With nearly $2 billion of assets, the VelocityShares Daily Inverse VIX Short—Term ETN (XIV) was a hugely popular trading product going from $6 to $145 over the space of seven years. However, the product’s holders were effectively wiped out in February 2018 when the Volatility Index (VIX) doubled almost overnight, losing 95% of their investment. Compounding the pain, a rule in the small print of the prospectus saw the product delisted shortly afterwards.
Delisting ETFs happens fairly frequently as products struggle to get to critical mass. If your ETF is delisted (just as a fund might be wound up), you needn’t worry as your cash will be returned. However, for investors with large taxable gains, redemption could trigger a tax bill later down the line.