Risk2Whenever there is a chance to gain through investments, there is risk involved, even with those trusty exchange traded funds (ETFs).

Matthew Hougan for Index Universe has some basic old-fashioned information about researching ETFs, what risks are involved, and what investors should look out for.

Here is what he outlined for a rough speech that was never delivered:

  • Label Risk: ETFs do not always hold the stocks that their name implies. For example, the iShares MSCI Pacific ex-Japan Fund (EPP) seems like a play on the Asian economies, but actually holds 67% toward New Zealand and Australia. Hong Kong and Singapore are treated like honorable mentions.
  • Tracking Error Risk: How well does the fund track the index you are buying? Does the ETF use “right weights” with equal weight given to each stock, or does it approach the index by optimization? This entails selecting a subset of the broader index that represents the whole. This can present more tracking error than actually tracking the entire index.
  • Spreads Risk: Trading risk or spreads risk deals with the liquidity of the underlying index. Average bid/ask spreads are correlated between fund size, trading activity and average spreads. Most ETFs have spreads under 10 points.
  • Tax Risk: For the most part, ETFs are tax efficient, but the specialized asset classes such as commodities and currencies are treated differently.
  • Counterparty Risk: This applies to currencies and competing leveraged funds. The direct ownership of stocks within the funds are not present. The risk involved relies upon another bank, or party.

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