WHY BUYING INDEX ETF’S ARE RISKY
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Why Buying Index ETF’s Are Risky

Why Buying Index ETF’s Are Risky

Just as an investor will benefit from the bull market rise, they will also suffer the consequences of overvalued shares during bear markets. Indices are constructed according to the weighting of each company's market capitalisation and free float. The largest companies receive the higher weighting in the index and in the ETF or index fund. Since the large shares account for the highest weighting in the index, when there's a downside in the market, the selling pressure on the largest stocks will be greater. For example, only 10 shares account for 44.5% of the S&P ASX 200 index, out of the 10 shares the big four banks dominate.

 

 

Another risk is that intra-day liquidity for ETFs can be challenging during market downturns. Algorithmic trading has exacerbated this risk. When there's a market dislocation and the ETF and index fund algorithms rapidly place sell orders to follow the market down (they are, after all, mandated to follow the index – regardless of direction) massive sell orders could trigger selling halts. Thus, the liquidity dries up, pushing investors to sell at significantly lower prices than the actual net asset value of the fund i.e. the ETF could perform worse than the index.

 

Source; S&P Dow Jones Indices as at 30th April 2018

 

 

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