Most of us are holders of both Exchange Traded Funds (ETFs) and single name company stocks. I am pretty sure that we are also all familiar with the valuation and market (systemic) risks in our single name stock investments. At least, we know those investments have a higher propensity for price volatility than our ETF holdings. But, it is equally important for us, as ETF investors, to know and understand the risks in our ETF holdings. In this way, we are able to recognize the market environments under which those investment instruments would come under pressure.

History and Benefits

ETFs have gained broad acceptance and popularity over the last decade – particularly since the 2007-2008 Financial Crisis.


Benefits and Risks of ETF’s (credit

The inspiration for this post was the following excellent paper by the folks at Bloomberg, The ETF Files, because it does a great job outlining the why’s and how’s of ETFs becoming such a ubiquitous part of modern investment portfolios. It also reveals some of the risks and concerns of their adoption, particularly in combination with algorithmic investing programs.

IOI loves ETFs as they provide inexpensive access to broadly diversified indices of nearly all shapes and sizes.  Indeed we discuss these structures in detail as part of our IOI 101 Course. If you’re a thematic investor, you can even create your own ETF structures through a variety of web based tools. If IOI were creating a “tracking portfolio” today, we would be using large, broad index ETF’s as a core holding for the above reasons. This allows to effectively start with the market return and then apply our value-driven investment method to add return (or “alpha”) on top of the market.  This approach works nicely in up or down markets as long as we have the ability to be effectively “short” as well as long.

The Risks and Concerns

But enough about us, what about ETF’s in your portfolio? Do you understand the risks that come with the benefits? Are you aware of the market conditions that could undermine an ETF structure? Did you know that the Securities and Exchange Commission continues to look very hard at ETFs, particularly leveraged ETFs, inverse ETFs and those tied to very narrow market sectors or commodity prices?

Here are just a few things to think about and be aware of as an ETF investor.

  1. ETFs carry “liquidity risk”.  Said differently, if everyone starts running for the door at once (mass selling), the ability of a large or small ETF to exit positions efficiently is compromised. In effect, ETFs can exacerbate market selloffs, particularly when the ETF position is being managed by algorithmic trading tools. The ETF is just an intermediary here, because investors are selling the ETF’s shares and those shares represent some commitment by the ETF to actual company shares in the market. So, as ETF shares are sold off, the ETF then has to rebalance it’s own holdings to reflect the new share price.
  2. ETFs can “inflate” the prices of index holdings. With ETF demand on the rise, particularly in the passive indices like the S&P500, just having your company named in that index increases demand for the Company’s stock, potentially reducing the liquidity of that specific company (the number of shares outstanding is finite and unrelated to ETF demand). So valuation can be distorted by these kind of demand effects on market prices.
  3. ETFs that are levered or inverse or tied to an underlying commodity are dangerous when not well understood. We’ve all seen these things out there; 2x S&P500, USO tracking oil prices, inverse ETF’s that allow one to invest in the downside risk to price of an asset. What is really really important here is to understand the construction of these types of ETFs. How does the ETF actually provide the marketed exposure? Most of the time, these kinds of ETFs or Exchange Traded Notes (ETNs) are using either options or futures to deliver these exposures. The investor sees this as “buying a share of” X, but the investment is actually a derivative of a derivative, and often times it is a time series of derivatives. See the example on crude oil ETF structures below (credit

    Risks of Crude Oil Linked ETFs (credit

    For us at IOI, there are very few if not zero situations where these kinds of structures are helpful to our portfolios. We urge extreme caution here. (The SEC has a great explanation about the danger of daily resets, and other details about derivative-based ETFs).

  4. Alternative-index ETFs are those that use some sort of calculation other than market capitalization weight to calculate what company shares are part of their “index” ETF and at what allocation. These include the now famous “smart beta” ETF crowd as well as whole host of other metrics that can include “quality” metrics, “riskiness” metrics and others as outlined in the graphic from PNC Bank below. Just as with the

    (credit PNC Bank)

    derivative-based ETF’s above, it is crucially important to look PAST the marketing materials and see how the index is built such that we can look at the resulting risks that might arise from such a basket of stocks.


Read the Bloomberg piece. It’s excellent and a must read for all of us who hold these instruments in our investment portfolios. You see some of the SEC’s concerns outlined in it. Just like with the companies we study at IOI, if we are not resolute about understanding exactly what we are investing in, we stand to accept risks in our investments that we are blind to – and that always ends badly.

What To Do Next

Your next step is to head to your portfolio and see what ETFs you’re holding today. Then get your hands on the prospectus for each of them (these are usually sent to you a couple times a year, but they can be downloaded online from the ETF provider easily) and bring them to IOI’s posted OFFICE HOURS or post questions you have about them in IOI Forums or simply shoot us an email using the form below. We want to ensure you’re as smart about these instruments as you are about the individual companies we analyze with you.

In the meantime, invest intelligently.

[caldera_form id=”CF56b3ac18bf490″]