The benefits and risks of exchange traded funds (ETF’s) are many and varied.
ETF’s can be bought and sold like ordinary stocks making the management of investors portfolios a snap and giving investors a great deal of control.
ETF’s offer investors the benefits of diversification
ETF’s often have very low costs and costs historically have been a key predictor of investors returns. The lower the cost of a fund the higher its predicted return
ETF’s can be purchased using margin lending facilities
ETF’s can be short sold, offering investors protection from other parts of the portfolio falling in value
ETF’s can provide easy exposure to specific market sectors/segments
The transaction cost of buying ETF’s can be significantly lower than the entry fees of up to 4% charged by some managed funds
ETF’s are tax efficient, because they normally follow an index the turnover within the ETF’s investment portfolio is relatively low and realised taxable gains are minimised
Transparency – ETF’s publish their investment holdings usually every day
ETF’s have a bid and an ask price and a spread in between the two. In time of market stress or ETF’s where the underlying portfolio is illquid the spread can grow and the market price may not reflect the net asset value of the underlying securities.
Not all ETF’s have low management fees. As the number of ETF’s increase the competition for funding is forcing the product spruikers to spend money on marketing.
All ETF’s have some level of tracking error, which is the degree to which they do not track the underlying index. ETF’s mission to track an index is not as easy as it first appears.
Liquidity – ETF’s often don’t actually hold all the shares or underlying assets of the index they are trying to track, because sometimes it is simply not practical. Many smaller stocks and some larger ones may not have the liquidity (e.g. there are not a sufficient number of buyers or sellers) which would allow large institutional ETF investors to buy and sell the underlying shares as required (see tracking error).
The transactions costs associated with buying ETF’s can be more than managed funds, it may be ossible for investors to obtain a rebate of some or all of the entry fees for managed funds.
It is estimated more than 20% of ETF’s listed in the US face closure due to an asset level of <$15m, investors do not always fare well when ETFs are wound up.
Stock lending – ETFs sometimes lend out the underlying stocks to earn extra revenue, this exposes them to counterparty risk
Counterparty party risk – is the risk that the other side of a contract will default.
Synthetically replicated ETFs are exposed to a higher degree of counterparty risk relative to physical replication funds.
Synthetically replicated funds mimic the return of their benchmark by entering a total return swap. Under the terms of the swap, the fund’s counterparty is obligated to deliver the return of the fund’s reference index in exchange for the performance of a basket of securities held as collateral, which the fund delivers to the counterparty. This arrangement exposes shareholders to the risk that the swap counterparty will fail to deliver the benchmark return.