Are ETFs really that invincible?

ETFs have garnered increasing popularity over the past few years and it’s easy to understand why. ETFs (Exchange Traded Funds) are a basket of stocks that are benchmarked against a particular index. This makes them diversified in nature and beginner-friendly for anyone to kickstart their investment journey. With ETFs, you can easily DIY a portfolio even if you’re not well versed with technical analysis. Not to mention ETFs generally have a low expense ratio (lower fees) as compared to actively managed funds.

However, despite their plethora of benefits, there is still room for ETFs to go south. That's right, you heard me right. I'm not trying to put down ETFs as an investment instrument, but rather I hope to provide a more holistic view of ETFs because it seems like the the risks associated with ETFs are not talked about as much as compared to their upsides.

Before diving straight into my points, I thought it will be good to list the different type of ETFs in the market:

Types of ETFs:

1) Index-fund ETFs

Index ETFs track an index and aim to give returns that match the benchmarked index. You've probably heard of the S&P 500 Index, which tracks the performance of the 500 largest companies listed on stock exchanges in US. VOO, SPY, VUSD are examples of Index-fund ETFs that track the S&P500.

2) Sector ETFs

Sector ETFs target specific sectors such as Healthcare, Technology, Financials. XLC, XLV, XLK are examples of Sector focused ETFs.

3) Thematic ETFs

Thematic ETFs form their basket of stocks based on a specific theme (ie. Cloud Computing, Cybersecurity, Clean Energy). They are specifically targeted to give potentially higher returns, but with it also comes more risk and volatility. When investing in thematic ETFs such as WCLD, CIBR, ICLN... apart from having conviction about that specific theme, you might also want to actively manage them especially if you're trying to use them to play a hot trend.

4) Inverse ETFs

Inverse ETFs are adopted mostly by hedge funds/traders to short against a specific index. This means that you can make money when the market or underlying index declines, without having to sell anything short.

5) Dividend ETFs

Dividend ETFs focuses on dividend paying stocks that can return investors with a stream of passive income. However, do note that you'll require a large starting capital to be able to receive significant dividends.

So what are the risks/cons of ETFs?

#1 Volatility

Wait what, ETFs are also subjected to volatility? Yes, you heard that right. ETFs are generally considered as low-risk investments, but with the rise of actively managed ETFs, this assumption is no longer extendable to all the ETFs out there in the market. Actively traded ETFs usually focuses on innovative and disruptive themes such as Cloud Computing, AI, Cybersecurity, Genomics, Clean Energy etc have the potential to commend much higher returns than your typical broad-based ETFs, but with that also comes higher risk and higher expense ratios.

Cathie Wood's ARK ETFs were one of the hottest additions to the ETF world, with ARK Investment Management rising to become one of the fastest growing fund managers in 2020. Notably, ARKK (ARK Innovation ETF) garnered 152.5% in 2020 and was ranked as the best fund in Morningstar's Mid-Cap Growth Category, however the performance of the ARK ETFs have been dissapointing in the year of 2021.

ARKK vs U.S. Market Index:

(Source: Morningstar)

The ARKK ETF has a highly concentrated portfolio, with focus on AI, Fintech, Biotech and Robotics. With only 44 holdings, Actively managed ETFs such as ARKK have a higher risk of volatility as there is less diversification to "smooth out" the returns should some of these holdings perform badly.

#2 Reality Check - Your returns are capped

One of ETFs' main attractive points is instant diversification. Hence, even if the share price of a company within the ETF goes to 0, the ETF will not go bust.

However, this goes two ways. It also means that if a stock within the ETF goes to the moon, your gains will be capped by the weight it has in the ETF.

#3 Risk of Closure

Just like any other business out there, the companies managing the ETFs need to generate revenue to cover their expenses. ETFs are at a risk of closure when they fail to generate enough revenue to cover their costs. Before you start to panic, the good news is that your investments won't plummet to 0 even if the ETF that you have invested in closes. However, the downside is that this can be a long and costly process.

Example of what happens when an ETF closes:

(Source: BanEck Vectors UCITS ETFs - Fund Closure FAQs)

If you'll like to find out more on how to Manage & Avoid ETF Closures:

https://www.etf.com/etf-education-center/etf-basics/managing-and-avoiding-etf-closures?nopaging=1#:~:text=Plenty%20of%20ETFs%20fail%20to,investment%20when%20an%20ETF%20closes.

#4 False Sense of Security

ETFs are highly recommended to anyone and everyone as an investment instrument because they can be done so passively and they are are relatively safe, while often used synonymously to refer to the market portfolio.

However, this notion that investing in ETFs will produce market-average returns is based on the assumption that you are invested in an broad-based ETF representative of the market portfolio such as a S&P 500 or MSCI World Index ETF. (Even so, these broadly diversified ETFs can still face significant fluctuation, especially in the context of a market-wide crash. Hence, it is recommended to have a long investment horizon - to not only let your investments compound, but also to have the buffer to ride out these fluctuations and market crashes.)

ETFs are still very safe, but we should note that what we are sheltered from is the risk of a individual stock pick going south. Not all ETFs will outperform or at the very least give you market-average returns.

#5 Lower Dividend Yield (Dividend ETFs)

In comparison to high-yielding stocks, the yields from Dividend ETFs may not be as high. The risk associated with investing into a Dividend ETF is usually lower but if you're looking to garner some passive income from dividends, it is recommended to opt for dividend stocks instead of ETFs.

To close:

ETFs are relatively safe and diversified in nature, with a low barrier to entry for beginners. While there are ways for your ETF investments to fail, this doesn't mean that it is a poor or bad investment instrument.

At the end of the day, every investment instrument has its pros and cons. Hence, it is important to take note of both the upsides and downsides to have a more holistic view of the what-if scenarios in the event that your investments don't go as planned.

(Image credits: Google)