The Hidden Risk Of ETF Investments

The Hidden Risk Of ETF Investments


In a matter of less than a decade exchange traded funds (ETF’s) have completely revolutionized the investment universe for retail investors.  In 2011 there were just 2 ETF’s listed on the ASX; Today there are over  100 exchange traded products ranging from ASX200 index funds to currency hedged emerging market funds which together command billions and billions of dollars in FUM.  Whilst the popularity of ETF’s cannot be denied there purported advantages can and should be brought into question.

The advocates of ETF’s will point to their diversification benefits, fees as low as 5 basis points and precise tracking of the underlying index.  However what these proponents of ETF’s will often overlook is how index tracking ETF’s fail to manage risk.

ETF’s are passive investments and as such aim simply to mirror the holdings of their underlying index.  ETF’s are thus not concerned with outperformance, optimizing asset allocation or reducing exposure to market and idiosyncratic risk. Rather obviously this can lead to complications.

The first and arguably most significant of these complications arises in periods of substantial market decline. Because ETF’s track an underlying index their asset allocation is fixed. For example the ASX200 is composed of 100% equity so ASX200 ETF’s are always effectively 100% invested in equity. In periods where the share market sees huge gains this strategy makes perfect sense, but when the market takes a sustained turn for the worse it appears far less logical. So although an ETF enjoys the full benefit of a bull market it can’t move into cash to protect its returns being ravaged by the succeeding bear market. This is in stark contrast to a more active approach to investing where a skilled portfolio manager can seamlessly move in and out of the various asset classes in order to make maximize gains on the upside and minimize losses on the downside.

The idea of ETF’s being a diversified investment also needs to be brought under the spotlight. Take the ASX200 for example, As at February 1st the top 5 shares BHP, NAB, CBA, ANZ and WBC account for approximately 31% of the index. In other words 31% of your entire investment hinges on how just 5 companies perform. A portfolio taking on that level of idiosyncratic risk hardly deserves to be labeled “diversified”.

ETF’s are always ultimately hamstrung by the quality of the underlying index. If the underlying index is well diversified and composed entirely of quality companies all valued at a fair or even discounted price then any investment in that index would make good financial sense. Unfortunately of all the stock market indices we have available to us none of them even come close to fitting this description.

Managing market risk is another area where ETF’s don’t quite stack up. Market risk is undoubtedly the most feared force in financial markets which is why money managers the world over have sought endlessly to hedge against this risk as best they can. These hedges take a number of forms from stop loss orders to put options all of which are designed to protect the investor from the downside whilst allowing them to enjoy the full extent of the upside.  These hedges allow the investor to potentially receive a comparable rate of return to the market without taking on the full extent of market risk. This is in contrast to ETF’s which simply accept the full weight of the market risk and as a result deliver the market rate of return.

Clearly then ETF investments don’t quite live up to what they’re made out to be in a number of key areas. Perhaps then many investors should be taking a long hard look at their index based investments and deciding whether or not they really are best for their portfolios.

HarbourSide Capital is an Australian provider of Managed Discretionary Accounts.

HarbourSide Capital Pty Ltd (ACN: 166 765 537) is a Corporate Authorised Representative (CAR No. 448907) of HLK Group Pty Ltd (ACN: 161 284 500) which holds an Australian Financial Services Licence (AFSL no. 435746). Any information or advice contained on this material is general in nature and has been prepared without taking into account your objectives, financial situation or needs.

Sources: Market Index, ASX

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