- Liquidity risk in ETFs arises from bid/offer spreads in daily price quotes – wider spreads indicate poor liquidity and vice versa.
- The only way to mitigate this liquidity risk is to pick ETFs that have larger fund sizes (upwards of $100 million) and a relatively consistent trading volume.
- Given the increasing number of ETF issuers/ sponsors – ETF names can be misleading and investors need to delve deeper into holdings of the ETF to mitigate this risk.
- For example an ETF for the same sector (say Emerging Markets) offered by two different sponsors might have varying ratios in which they provide exposure to the represented countries/ regions.
Tracking Error Risk
- Tracking error refers to the variation in the price/ value of the ETF as compared to the underlying index that the ETF replicates. Tracking errors can result from:
- A temporary demand/ supply mismatch in trading volumes – that increases spreads between the buying and selling price and results in the ETF trading at a premium/ discount to the underlying index.
- Use of creative processes to replicate the underlying index – by using statistically significant samples and mathematical formulas that try to optimize the holdings.
- Expenses and fees associated with the ETF – that will cause the ETF to trade at a discount to the level of the underlying index that it replicates.
- Dividend reinvestment policy – where ETFs that hold dividends and only payout cash on a periodic basis may trade at a discount.
- Rebalancing holdings – the time lag between the changes made in the underlying index and the rebalancing done in the ETF portfolio to reflect the same may cause a temporary mismatch in prices.
- Different time zones – ETFs that track an index in a market that is closed during US trading hours (example a US listed ETF that tracks the Indian Stock Market) will always trade at anticipatory prices that are at a premium/ discount to the underlying index.
- ETFs have opened up new asset classes (such as commodities, currencies) for retail investors – while this is great for diversifying market risk – some of these new asset classes are taxed differently as compared to Equities.
- Investors need to be well aware of varying tax rates that are applicable to some these transactions. For instance, profits from physical commodity holding ETFs have a 28% tax rate as compared to the 15% long term capital gains tax applicable to equities.
Counterparty Credit Risk
- Counterparty risk refers to the risk of the fund sponsor/ issuer going under.
- Some Exchange Traded Products such as ETNs are essentially unsecured debt instruments issued by the Sponsor (e.g. Barclays Bank). Recent history shows that the most venerable of Banks can vanish overnight and investors need to do their own due diligence to mitigate this risk.