Watch Out: The Risks of ETFs

The trading cost structure of an ETF is probably best described via juxtaposition with a comparative mutual fund. In order to buy and hold a mutual fund, investors must not only pay the expense ratio but also a host of other fees including: loads (e.g. commission, sales charges), marketing fees, and trailing commissions. Mutual fund expenses can be cut down by shopping for low-cost distribution channels, no-load funds, or brokers who charge a flat-fee. Often times, no-load mutual funds are available and do not charge per trade creating a tremendous incentive for investors who periodically add new money to their investments (e.g. pound-cost averaging).

By comparison, ETF providers do not charge above and beyond the expense ratio listed on its prospectus. There are no marketing or trailing commissions. However, when purchasing an ETF, brokerage houses typically charge a trading commission--just like trading a stock. If investors trade frequently or pursue pound-cost averaging strategies, ETF trading costs can stack up and potentially erode any cost-savings derived from the lower expense ratio.

In the past few years, however, certain European brokerage houses have adopted commission-free ETF trading on a handful of select ETFs. If your brokerage house offers these types of deals, then you are in luck! The advent of commission-free ETF trading means that one of the chief drawbacks of ETFs relative to traditional funds has been removed.

Tracking Error
Investors who purchase an ETF are relying on it to deliver the underlying index return. However, in practice, ETFs tend to diverge somewhat from their reference indices. "Tracking error" is when an ETF does not perfectly mimic returns of its index.

Some level of tracking error is normal and should be expected. Management fees charged by the ETF provider are a direct (and often the largest) contributor to tracking error. However, even after adjusting for management fees, most ETFs will still have some residual tracking error. Other sources of tracking errors include tax treatment and dividend timing. ETFs using the physical replication method exhibit larger tracking errors compared to ETFs that use synthetic replication.

In practice, the divergence between most ETFs and their reference indices is generally quite small, but investors should be mindful of this difference and seek to understand the reasons behind it when conducting their due diligence.

Counterparty Risk
In recent years, the issue of counterparty risk has been vaulted to the forefront and caused much debate within the European ETF industry, despite the fact that this sort of risk has existed for decades in nearly every fund structure on the planet Counterparty risk is essentially the risk that someone who promises to do something, fails to follow through on their promise.

For ETFs, counterparty risk arises primarily from two practices: securities lending and synthetic replication.

Synthetic replication ETFs track their designated indices via swaps--essentially a bank or other institution's promise to provide the return of the index to the ETF in exchange for the return on a separate asset basket. Investors in synthetic replication funds face the risk that the swap’s counterparty will fail to deliver the index return. In practice, this risk is mitigated via collateralisation of the fund’s swap exposure. In return for assuming this extra risk, synthetically replicated indices tend to offer lower tracking error and lower fees than their physically replicated peers.

Securities lending is a decades-old investing practice where a fund lends some of its holdings (e.g. stocks, bonds, etc) to another market participant for some period of time with the promise that borrower will return them at a later date. Investing veterans will know that borrowing securities in this way is the basis for short-selling. Despite the historical acceptability of this practice, ETFs have recently come under scrutiny for their lending practices. However, several fail-safes are typically put in place to shield investors from counterparty risk associated with securities lending including collateral requirements and debentures. Moreover, ETF investors tend to benefit from this practice as it generates additional income for the fund, which is usually passed through to investors.

For more in-depth analysis, Morningstar's team of ETF analysts has been at the forefront of the industry discussion regarding both synthetic replication and securities lending practices at major European ETF providers.

Lack of Investor Education
Finally, ETFs remain a relatively new investment vehicle. As such, many investors are still learning about these products and how to use them within their portfolios. Unlike the previously listed ETF drawbacks, however, this is not a structural deficiency and can be overcome. At Morningstar, we hope to provide you with the tools and educational content needed to understand how to best use these products in your own portfolio or on behalf of your clients.

Lee Davidson is an ETF analyst with Morningstar