The Biggest Downside Risk You Face With ETFs

“It would take something catastrophic to happen. We would have other things to worry about at that point.”

The first ETF launched in 1993. It took sixteen years for the ETF industry to surpass $1 trillion in assets.

It hit that milestone in 2009. The industry topped $4 trillion in assets only eight years later.

It’s predicted that the ETF market will hit $10 trillion by 2020.

Here’s a chart showing the percentage change in assets since 2001…

Source: etfdb.com, highcharts.com

As you can see, ETF assets have grown over 2,000 percent. During the same time, mutual fund assets have grown just over 100%.

The ETF industry is still smaller than the mutual fund industry. Which has assets just over $17 trillion.

But ETFs are growing fast.

A few months ago, I sat down to talk about ETFs with a V.P. from BlackRock. BlackRock is the world’s largest asset manager.

I asked him about the risks involved for individual investors in buying ETFs (Exchange-Traded Funds). I wanted to know how they work.

Can an ETF go bankrupt like a company? In other words, if you buy an ETF, the chance that it could go to zero and lose all your money.

What happens when another global financial crisis comes along?

I wanted to know more because they seemed to be a great tool for the individual investor. As I wrote last week, they give the individual investor access to the same opportunities and strategies as a hedge fund manager.

In short, he told me the biggest risk is exchange risk. Meaning that the entire stock market exchange (for example, like the New York Stock Exchange) would have to shut down.

The only way that would happen is if something catastrophic happened. Like a major war or something that could wipe out the exchange.

Obviously if that happens, survival becomes more important than worrying about ETF investments. The same goes for stocks or bonds.

But ultimately, investors still own the assets (like stocks) underlying the ETF.

There are a few other risks involved.

There’s the chance that an ETF provider (for example, Blackrock) could go under.

If an ETF provider went under, the underlying assets still belong to investors. The only difference is that a new advisor would take the ETF over and manage it.

For example, let’s say you hold an energy ETF. Maybe it holds companies like Exxon, Chevron, Conoco Phillips etc.

The companies are still making money and doing business. Nothing changes. Just the ETF provider.

Instead of it being the XYZ Select Energy ETF it’s now called the ABC Select Energy ETF.

Another risk is lack of price discovery.

In an economic shock, the ETF price could drop significantly. There could be a breakdown of price discovery between the ETF and the stocks inside the ETF.

For example, the ETF could drop in price from $50 to $5. Yet, the underlying assets don’t fall as much in price. Maybe they individually add up to a value of $27.

If so, they could halt redemptions until the market calms down. But again, the underlying assets (Like Exxon, Chevron etc.) still belong to the investors.

It’s not much different than owning a stock. If the market tanks, the price may drop 30%.

You may not like the new price. But there will always be someone willing to step in (like a market maker) and offer a bid at the lower price.

In other words, the process of matching buyers and sellers continues.

There’s one other risk within the ETF industry. When you start looking at investment opportunities within ETFs, you’ll come across something called ETNs (Exchange-Traded Notes).

ETNs are senior, unsecured, unsubordinated debt securities. A bank or specialty finance company usually issues the notes. Like ETFs and stocks, ETNs trade on an exchange (like the New York Stock Exchange) and can be shorted.

This structure gives investors access to difficult-to-reach sectors or strategies. You’ll find that the commodity sector consists of a lot of ETNs.

For example, if you want to get exposure to sugar, you could buy ticker symbol SGG (iPath Bloomberg Sugar Subindex Total Return ETN).

ETNs don’t have underlying assets inside them like ETFs do with stocks. The issuer pays the return of the benchmark index it says the ETN tracks.

The big risk with ETNs is credit risk. You have counterparty risk because it’s backed by the credit of the issuer. The investor is like an unsecured creditor of the bank.

If the issuer fails, you lose your money. The ETN is not FDIC insured.

For example, Lehman Brothers issued ETNs. It went bankrupt in 2008 during the peak of the financial crisis.

There are a lot of investors who would never touch an ETN. If you’re interested in buying one, make sure you know who the issuer is and if it’s a safe institution.

It’s kind of like investing in a bank. You want to invest in one that is well-capitalized and doesn’t speculate with depositor’s money.

The past couple of essays have been a crash course in ETFs and ETNs. If you’ve been looking for investment opportunities and you don’t want to do deep dive company research, these are a good place to start.

ETFs are a great tool for investors. ETNs can have a place in an investor’s portfolio too. Especially if an investor is looking to get direct exposure to difficult-to-reach commodities.

The Champion Investor philosophy doesn’t change when buying ETFs or ETNs. Just like with buying shares of stock, the price you pay is the single biggest driver of future returns.

You want to buy low and sell high. You don’t want to follow the herd.

Not everyone can do it. It takes a lot of courage do something different than the majority.

More on this tomorrow. Stay tuned…