Know your ETF risk

Trading ETFs requires some homework as they do have expenses, and one of the pillars of trading is to understand your ETF risk. 

Image courtesy Rafael Matsunaga:

ETFs require homework, just like any other financial instrument

Basically ETFs are designed to track indexes, sectors, or a basket of assets such as commodities, stocks, or bonds. ETF fund managers deploy strategies to achieve the goal of the function of the ETF. However, a fund manager can position and deploy different strategies to become more defensive or less defensive in market swings, which in turn can have a ripple effect on price downstream.

Hopefully you caught that ETFs do indeed have fund managers and unfortunately they do not work for free. This means that similar to mutual funds, there are expenses associated with each and every ETF, and they vary from one another.

Fees can be found within an ETF’s prospectus and most brokers will list the fees in a detailed quote. It is typically expressed as a percentage ratio of gross and net expenses.

Because ETFs have expenses and are attempting to track some asset(s), they will inherently have some tracking errors. Since expenses vary from ETF to ETF, similar ETFs may track better or worse due to the expense ratio and fund manager’s strategy. This holds especially true within complicated commodity ETFs and how their strategies are deployed.

With the explosion of ETFs into foreign and emerging exchanges, you also need to be aware of added risks that you may not get for equities listed on the New York Stock Exchange.

For example an ETF listed on the U.S. exchange that tracks a basket of Russian stocks traded on Russia’s stock exchange is exposed to currency exchange risk. 

The currency fluctuations can have a positive or negative effect on the underlying value affecting the ETF’s price.

While on the subject of foreign ETFs, you need to be aware of volume, or the lack of volume in many cases. Many ETFs attempting to track tight or small sectors around the world may not be traded all that often, and in some cases it can take days for an order to be filled, such as with the iShares MSCI Hong Kong Small Cap Index (EWHS, quote).

Never jump into a position without knowing what the ETF’s function is: not every ETF name is an accurate description of the function. Beware, read through the information provided by the fund managers, and make sure the ETF is suitable for your strategies and risk tolerance.

Not every ETF has been created for longer term investors; some are even created for very specific types of investors who may be professional.

Today many brokers offer free commissions for a set of ETFs for longer term investors. These ETFs are a great starting point even if you do not plan on holding the ETF for long, because most of these are liquid and have reasonable expenses. This is NOT a green light to skip your homework; it’s just a starting point.