While investing in ETF is generally preferred by many as a safe and diversified way to invest, there are some hidden dangers too. Let’s find out what they are and I hope you can make a more informed decision in ETFs. In the recent years, the interest in ETF has been exploding. For example, the total U.S. ETF assets just went above $4 trillion, which is about three times of the total amount six years ago. But is it really a sure-fire way to win?

Source:Valuewalk

Here’s How It Works

Jack Bogle, the person who started ETF
Source:Philly.com

For those who have yet to encounter ETF (Exchange Traded Fund), they are basically funds that are traded freely on the stock exchanges. Their main feature is that they mirror the performance of indexes by holding similar stocks (some may not even hold the stocks) as the indexes.

For example, if you want to invest in the US S&P 500, you can invest in the Vanguard S&P 500 ETF (VOO) which mirrors the performance of the US S&P 500. Therefore if the S&P 500 goes up, the VOO should goes up too.

Concentration Risk

Most ETFs aims to mirror the performance of indexes, and these indexes are usually dominated by the biggest companies in the stock exchanges. For example, the single factor that determines whether a company is in the US S&P 500 – Market Capitalisation. This means the top 500 companies in market value, and this is measured by (the number of shares in the market X the stock price).

One of the key benefits of ETF that attracted many is DIVERSIFICATION. “If I invest in US S&P 500, I am diversifying into 500 companies and across various industries!”

Let’s see if that is true.

For instance, if VOO is equally weighted across all the 500 companies in the US S&P 500 then each company should only account for 0.2% of the whole ETF. However, in reality, the higher the company’s market value, the more index weighting is given to the company.

As you can see below, the top 10 stocks already account for 20% of the ETF! And, Apple single-handedly accounts for 3.6% of the whole S&P500. Since when do 10 companies represent the whole US stock market??

Source: Vanguard

Therefore, as more money is invested in ETFs, more money is disproportionately invested into these big companies simply due to their weighting in the index. This could lead a concentration risk on this few companies.

Also, you may have noticed that the top 5 stock in VOO are all Info-Tech companies, accounting for more than 10%. This means if the Info-Tech industry were to suffer a crisis, it is likely the whole VOO ETF will suffer as well. Therefore, the idea of sector diversification through ETF is not necessarily true all the time.

Leveraged and Exotic ETFs

With this amount of money following into ETF, more new ETFs are created to capture the $$ and we are also seeing exotic ETFs sprouting out of seemingly nowhere! Such as ETF on restaurants, cloud computing, handbags and even cybersecurity. There are also highly leveraged ETFs that claim to perform 3 times that of the index. While these ETFs claims to provide easy access to invest into new markets, we must be very careful about the holdings of the ETF and how it is made.

For example, there is a new ETF that tracks an index on Cancer! Thinking that curing cancer will be multi-million industry, I decided to take a look and I was expecting to see the big pharma names that I’m familiar with but when I look deeper…

I Don’t Und….
(Source: etf.com)

Perhaps, I am ignorant and very often I am, I found none of these names familiar at all.

So if you want to invest in exotic ETFs, you need to read a lot more about them. Such as how do they track the index of these companies? There is no standard S&P500 index for curing cancer that they could mirror. And how do they select the companies? Is it equal weighting or market capitalisation?

Of course, there are also highly leveraged ETFs, such as Direxion Daily Gold Miners Bull 3X ETF (NUGT) which claims to give you 3x the return of the gold mining companies. However, they may have failed to mention that if the stock of gold mining companies were to fall, the price of NUGT will also fall and 3x worse!

And that’s what happened when Trump was elected President. The gold price fell by a little but the NUGT shares fell by 40% over 3-4 days following the US elections. I guess NUGT overpromised their multiplier. It was more like 7x loss.

Source:etf.com

By and large, I still think ETFs are beneficial to investors. They provide a low-cost, relatively low risk and easy access to to the market indexes.  However, investors need to be more aware of what they are buying into and not blindly sinking their hard earned money into any thing that comes with a tag of “ETF”.

In this case, I think simple is better, stick to those plain vanilla ETFs that tracks the major indexes, non-exotic and non-leveraged. If you can find one that is equal-weighted instead of market- size weighted, you will better be able to diversify properly.

pssss….. I recently found a new type of ETFs…. it is called ETF of etfs… In case you are too lazy to even buy ETFs individually, you can buy this mother of ETFs… I wonder whats next? 

See you soon!

Investing Always,

Pete

Please refer to the disclaimer here