Exchange traded funds are continuing to experience record inflows this year as more investors clamor to the space. The chance at high returns in a vehicle that is more tax-efficient is an investment opportunity that many are jumping to, but it’s important to look beyond just the recent returns when considering ETFs.
It isn’t an uncommon practice for investors to only consider returns when deciding which ETF to invest in, but taking a step back to consider the bigger picture means weighing risk exposures, an important aspect of investing that shouldn’t be overlooked. A holistic investment strategy is one that provides risk-adjusted returns that are balanced to the needs of the investor; advisors should ensure that they are accounting for the risk profiles of their clients and the assets they are interested in.
One of the primary risks that advisors need to consider is the liquidity risk of their investment. Liquidity risk is the risk that buying or selling quickly in large enough portions would impact the market price. This occurs most frequently in smaller markets that don’t have high volume trading.
Investors and advisors need to research the market and determine the volume of trades (average daily trading volume) ahead of time to ensure that there is enough liquidity in the space for their investment. ETFs that are focused on more specific, smaller categories or industries are most prone to liquidity risk.
Volatility is a major risk that investors today are somewhat familiar with; it is the risk of wide price movement brought on by any number of mitigating factors. Fears of inflation have markets wobbling recently as they experience broad volatility. Technology ETFs have also experienced pronounced volatility in the past several months.
Volatility is created by any number of things but can also be exacerbated by the assets carried within a fund; for example, crypto ETFs would experience greater fluctuations because of their nature within crypto markets than a bond ETF would.
A third risk to consider when investing is that of concentration, or what happens when funds are non-diversified. This happens when a fund or investment strategy focuses solely on concentrating holdings within an area without diversifying and can look a few different ways.
ETFs that hold a lot of securities but all within similar areas, such as real estate, would be opening themselves up to risk if the housing market was adversely affected, whereas a fund holding some investments in real estate but also others in other markets wouldn’t feel the negative impacts as much. Conversely, ETFs with only a few securities can open themselves up to concentration risk by not having diverse enough options simply because there are too few assets to spread any adverse impacts across.
Active management firm T. Rowe Price believes in the difference and benefits to active investing and active management as it works to provide risk-adjusted returns for investors. The firm currently offers eight actively managed ETFs with a variety of strategies for investors to align their risk exposures and investment goals. The firm brings a bevy of experience and research to its products, with portfolio managers averaging over 20 years in investing each, as well as over 400 investment professionals dedicated to researching companies within ETFs.
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