The risks of ETF investing and how to manage them

In another article, we discussed more advanced strategies using leveraged, inverse, and synthetic ETFs. Now, let's explore this topic further.

While ETFs offer many advantages for investors, they aren't without risks. Understanding these potential pitfalls and how to mitigate them is essential for Saxo Bank clients looking to build successful long-term portfolios. Let's explore the key risks associated with ETF investing and practical strategies to manage them.

Market risk: the unavoidable reality

Market risk—the possibility that the entire market will decline—affects all investments, including ETFs. When the underlying market falls, even the best-managed ETF tracking that market will fall too.

Mitigation strategies:
- Diversify across different asset classes (equities, bonds, commodities)
- Consider allocating to defensive sectors like consumer staples or utilities
- Maintain a long-term perspective through market cycles
- For conservative investors, include bond ETFs to reduce overall portfolio volatility

Real-world example:
During the 2020 market downturn, a globally diversified portfolio with 60% equity ETFs and 40% bond ETFs experienced significantly less volatility than an all-equity portfolio, helping investors stay the course rather than selling at market lows.

Liquidity risk: when trading becomes difficult

Liquidity risk refers to the potential difficulty of buying or selling an ETF at a fair price, particularly during market stress. Some ETFs, especially those tracking niche markets or less liquid assets, may experience wider bid-ask spreads during volatile periods.

Mitigation strategies:
- Focus on ETFs with higher average daily trading volumes (preferably 50,000+ shares)
- Check the ETF's assets under management (larger funds tend to have better liquidity)
- Use limit orders rather than market orders when trading
- Avoid trading during the first and last 30 minutes of the trading day

Real-world example:
During market turbulence, a thinly-traded frontier market ETF might see its bid-ask spread widen from 0.2% to 2% or more, significantly increasing trading costs. In contrast, a major S&P 500 ETF typically maintains tight spreads even during market stress.

Tracking error: when performance deviates

Tracking error measures how closely an ETF follows its benchmark index. Higher tracking error means the ETF isn't accurately replicating the performance of its target index.

Mitigation strategies:
- Review the ETF's historical tracking error before investing
- Compare similar ETFs to identify those with consistently lower tracking error
- Consider physically-replicated ETFs for major markets, which often have lower tracking error than synthetic alternatives
- Be particularly vigilant about tracking error in less liquid markets

Real-world example:
Two ETFs tracking the same European equity index might have tracking errors of 0.1% and 0.4% respectively. Over a 10-year period, this difference could result in a performance gap of several percentage points, significantly impacting returns.

Counterparty risk: the third-party factor

Counterparty risk is primarily a concern with synthetic ETFs, which use swap agreements with financial institutions to replicate index performance rather than directly holding the underlying assets.

Mitigation strategies:
- For core portfolio holdings, consider physically-replicated ETFs that actually own the underlying securities
- If using synthetic ETFs, check the collateral policies and the financial strength of swap counterparties
- Limit exposure to synthetic ETFs to a reasonable portion of your overall portfolio

Real-world example:
During the 2008 financial crisis, concerns about counterparty risk led to significant outflows from synthetic ETFs as investors worried about the stability of the banks providing the swap agreements.

Concentration risk: too many eggs in one basket

Some ETFs, particularly sector or thematic ETFs, may have high concentrations in a small number of companies, potentially increasing volatility and risk.

Mitigation strategies:
- Check the ETF's top holdings and their weightings before investing
- Be cautious of ETFs where the top 10 holdings represent more than 50% of the fund
- Balance concentrated ETFs with broader market exposure
- Consider equal-weighted ETFs for sectors where you want to reduce single-stock concentration

Real-world example:
A technology sector ETF might have over 40% of its assets in just five large tech companies. If these companies underperform, the ETF will likely underperform the broader market significantly.

By understanding these risks and implementing appropriate mitigation strategies, investors can build more resilient ETF portfolios designed to weather various market conditions while still capturing the many benefits ETFs offer.