Described as bundles of stocks, bonds or other investments that trade as if they were a single stock, affordable exchange traded funds (ETFs) have become a handy way to diversify into several sectors. But it’s not always smooth sailing.
While ETFs have helped keep many investors in the market by allowing to play bullish or bearish sentiment, experts say that there there are three often-hidden risks in particular that many investors are unaware of, says J. Alex Tarquinio for The Wall Street Journal.
- Vanishing funds: For each ETF, the investment company that sponsors the fund needs a certain amount of assets — typically, at least $50 million — to generate enough fees to make a profit. So if investors don’t take to a fund, the sponsor typically shuts it down. Today, more than 40% of ETFs fall below the $50 million threshold.[The ETF Supermarket Has Arrived.]
- Missing their target: Tracking error is a factor in many ETFs, in varying degrees. The average, according to Morgan Stanley Smith Barney, is 1.25%. The jump has been attributed to the increase in ETFs that track niche sectors that are more difficult to trade as well as commodity ETFs, which can take a hit if contango is present. The easiest way to mitigate the effect of tracking error is to understand how the ETF you’re buying works.
- Leverage and losses: Leveraged ETFs let ordinary investors double or triple the market’s moves. Those wide day-to-day swings make leveraged ETFs unusually volatile and high-risk. The ETFs are not for everyone, especially if you’re buying and holding. [Don’t Blame Leveraged ETFs.]
Tisha Guerrero contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.