Exchange-traded funds are a core part of many investors' portfolios. But they carry some unique risks you may not have thought of.
ETFs carry market risk, or the risk that prices will go up and down. This is true of any type of investment. But here are two other ETF risks that can seriously damage your portfolio -- and what to do about them.
Beware of ETFs That Use Derivatives and Leverage
To stand out in an increasingly crowded field, ETF providers have created increasingly exotic ETFs -- some of which are very risky. This includes leveraged and inverse ETFs.
Leveraged ETFs are designed to earn returns that are two or three times that of their underlying index. The ProShares UltraPro Short S&P 500 (SPXU) - Get Report is one example. Its mandate is to earn three times the opposite of what the S&P 500 returns in a day. So, this ETF would go up 3% if the S&P 500 loses 1% in a day.
An example of an inverse ETF is the ProShares Short S&P 500 ETF (SH) - Get Report . It aims to do the opposite of what the S&P 500 does, but without the leverage. So, if the S&P 500 climbs 1%, this ETF loses 1%, and if the S&P 500 loses 1%, SH climbs 1%.
Leveraged and inverse ETFs both use derivatives. As the name implies, a derivative's value is "derived" from the price of an underlying asset, like oil, silver or a stock index. Derivatives are used by ETF managers to mimic or amplify a target index's returns.
But the thing a lot of investors ignore about leveraged and inverse ETFs is that they track daily returns. If you hold them for longer than a day or two, the ETFs significantly underperform the indices they track. And they can kill your returns.
Here's an example to illustrate:
Let's say you buy a 2X leveraged ETF that tracks the return of XYZ index. You buy 1 share of the ETF for $10, and the underlying index is at 1000.
If XYZ spikes 10% the next day to 1100, your 2X leveraged ETF would increase 20%, to $12.
But the following day, the index falls back down to 1000 - a 9.09% drop. This would mean that your 2X leveraged ETF would lose twice this amount, or 18.18%.
Losing 18.18% means the price of the leveraged ETF would go from $12 to $9.84. So, over those two days, the value of XYZ index hasn't changed -- it started at 1,000 and ended at 1,000. But the value of the 2X ETF has dropped 1.6%!
Of course, indices normally don't move 10% in a day. But even a series of smaller changes over a longer period of time will affect returns.
Another related risk is tracking error. This is the risk that the ETF will not accurately track the performance of its underlying index or asset.
For example, let's say earlier this year you invested in an ETF that tracks the price of oil because you felt oil prices had bottomed out. So, on Feb. 11, you bought shares in the United States Oil Fund ETF (USO) - Get Report . If you held it until mid-October then sold your shares, you would have made 44% on your investment. That's a very good return.
But, as shown above, the price of oil (WTI, in this example) rose 92% over the same period. So, your very good return was less than half of the return of the underlying asset.
This shows the problem with ETFs like USO. They can be terrible at tracking the price of their underlying asset. In this case, you made the right call, and earned a good return, but it was still less than the price of the asset you were trying to invest in.
ETFs and Flash Crashes
On Aug. 24, 2015, U.S. stocks experienced a "flash crash." As soon as the stock market opened, stocks started falling -- due in part to an overnight drop in Asian stock markets.
That same morning, 20% of U.S.-traded ETFs fell by 20% or more. Some fell more than 40%. Some ETFs saw their values drop more than the indices or stocks they tracked.
How could this happen?
An ETF is valued two ways: its share price and the fund's net asset value (NAV). The share price is what investors pay to own the ETF; the NAV is the value of all the assets the ETF holds, less expenses.
Normally, an ETF's share price and NAV are nearly identical. That's because of "authorized participants," large investors ETFs empower to trade away discounts and premiums for their own profit.
So, if an ETF's share price differs significantly from its NAV, the authorized participant would either go long or short on the individual stocks and do the opposite with the ETF to "arbitrage" a profit. This causes any spread between NAV and ETF prices to narrow.
However, on this August morning, because share prices were violently crashing, the authorized participants couldn't calculate the ETFs' NAVs accurately. So, they stayed out of the market and let other investors set the share price.
When these other investors -- mostly smaller investors who didn't know or understand what was happening -- saw the stock market crashing and the value of their ETFs collapsing, some panicked and sold.
Or, some investors with preset stop-loss orders (including large investment companies) saw their ETF positions sell automatically. (That's why it's better to keep a mental stop-loss, instead of telling your broker the price you're willing to sell.)
All this selling made the situation worse.
Thankfully, by the afternoon ETF prices went back to "normal" as the market settled down.
But if an investor panicked and sold during the "flash crash" he would have locked in losses. Or, if the ETF sold automatically when prices fell to their stop-loss level they would have also lost money. It would have been especially painful to watch prices climb back up by the afternoon... after selling in the morning.
How to Avoid the Risks
ETFs are one of the best ways to invest. But like any other investment they carry risks, some of which are unique.
But these risks can be minimized by following these steps:
Understand what you're buying. If you don't understand how derivatives work, or if you can't figure out how the ETF works, just avoid it.
Don't panic and sell if an ETF is trading for less than its NAV, especially during a flash crash. If it's trading for less than its NAV, it's a great opportunity to buy it. And don't leave a standing sell order with your broker -- it might be filled at the worst possible time.
Invest in easy-to-understand ETFs that track a well-known index. It's almost impossible to outperform an index's performance consistently anyway, so stick with what works.
Kim Iskyan is the founder of Truewealth Publishing, an independent investment research company based in Singapore. Click here to sign up to receive the Truewealth Asian Investment Daily in your inbox every day, for free
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.