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ETF Risk

ETF Risk

💡 Take Away

  • You can’t completely avoid risk when investing—returns are the reward for taking that risk.
  • Market risk affects all investments and refers to stock market fluctuations (volatility).
  • Niche ETFs investing in illiquid assets can become hard to sell during market downturns.
  • Panic selling often happens when prices drop sharply, but patience helps ride it out.
  • Swap-based ETFs and those lending securities carry counterparty risk, though usually backed by collateral.
  • Currency risk exists when investing in foreign currencies, but major ETF currencies are generally stable.

Returns Through Risk

  • Return (Rendite) is the profit you make from an investment.
    • In the stock market, it’s the reward for taking risks—the higher the risk, the higher the potential return, if things go well.
  • Volatility measures how much a security fluctuates; higher volatility means greater risk.
  • You only lose money when you sell at a loss—before that, it’s just a paper loss.
  • Diversifying your portfolio reduces the impact of individual stocks.
  • Every investment has risks, but being aware of them helps you develop strategies to manage and minimize them

Different ETF Risks

ETF_risks

Market Risk

Exceptional situations, such as the COVID-19 pandemic, can impact the entire market. In such cases, every company is affected to some extent. You can not avoid market risk when investing—it exists for both individual stocks and global ETFs.

The best way to manage this risk is to invest for the long term. This allows you to ride out crises instead of panic-selling your shares. Unlike company-specific risks, market risk can not be diversified away.

Liquidity Risks in Niche ETFs

Some ETFs track cryptocurrencies, gold mines, or real estate assets. During crises, highly specialized ETFs may face liquidity shortages.

  • This happens when the underlying securities are illiquid, meaning they are traded infrequently.
  • In the worst case, you might not be able to access your money immediately if you want to sell your ETF shares đŸ˜±. However, such situations are rare in practice. This risk is not inherent to ETFs in general but arises because some ETFs are highly theme-focused.

We recommend investing in broadly diversified global ETFs instead.

Panic Selling

Triggered by a specific event, many ETF investors might decide to sell their shares simultaneously. -> When many sell, the supply increases, and the price drops. -> The lower price, in turn, may encourage even more investors to sell their shares.

Panic selling can occur with any type of investment. ETFs come with relatively high volatility, and prices can sometimes fall for years. Investors should avoid making rash decisions in response to market conditions.

Panic Selling

Stock prices can fluctuate significantly. When a stock drops abruptly, investors fear a sharp loss in value and rush to sell their shares to save as much of their capital as possible. This further drives prices down, creating a downward spiral. This phenomenon is called panic selling. Panic selling can significantly worsen economic crises.

Swap Counterparty Risk

Synthetic ETFs do not directly purchase the individual assets of an index but replicate it through a financial derivative. The ETF provider enters into a swap agreement with a financial institution (the swap counterparty). This introduces counterparty risk: Theoretically, the swap partner could go bankrupt, jeopardizing the ETF’s returns.

According to EU regulations, the performance difference between the collateral portfolio and the swap portfolio must not exceed 10%. If this threshold is breached, the swap must be reversed. For example, if the MSCI Emerging Markets is at €100 and the collateral portfolio is at €110, the swap must be reversed at that point. The same applies if the MSCI Emerging Markets is at €100 and the collateral portfolio is at €90. Most ETF providers reverse the swap well before reaching the 10% threshold.

Securities Lending

  • Some ETFs lend out securities and receive a lending fee from the borrower. This generates additional income, which is usually passed on to you as an investor.

-> Risk: If the borrower goes bankrupt, they may not be able to return the securities.

  • In Europe, the maximum amount of securities that can be lent out is 20% of the portfolio value.

  • The borrower must provide collateral, such as government bonds or cash, to the lender. If the value of this collateral exceeds 20% of the portfolio value, the ETF can lend out more securities.

  • As an investor, you are protected from significant losses.

Currency Risk

  • Some of the largest funds, including certain MSCI World ETFs, are denominated in US dollars.
  • Like any currency, the dollar fluctuates against the euro.
    • If the dollar is worth less at the time of your sale compared to when you bought it, your returns will suffer.
    • This currency risk can also be an opportunity if the exchange rate moves in your favor.
  • For long-term, globally diversified investors, these fluctuations largely balance out. (Mathematically, exchange rates are a zero-sum game.)

Conclusion

Like any investment, ETFs come with risks. However, most risks are well-hedged and therefore do not necessarily pose a disadvantage for you.

As an ETF investor, you are most exposed to market risk. By investing in broad market segments, you bear the full impact of market fluctuations. Historically, the global economy has always shown positive long-term growth. Early investors who remained patient and held their shares for the long term were rewarded đŸ’Ș.

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