ETF without risk? Unfortunately, there is no such thing. Even the safest ETF has risk to money loss. And then there are plenty of examples of high-risk Exchange-Traded Funds. In this article, you'll read all about the risks of trackers. We also give 5 examples of high vs. low risk ETF.
On to sustainable (financial) success!
ETF Risks: the potential dangers of ETF investing
ETFs are a breath of fresh air for risk-averse investors who want to participate in the stock market. However, today there are many different types of ETFs, each with its own risks. There are major differences between lower-risk and higher-risk ETFs. In this article we will look at examples.
The biggest risk with ETF is the market risk.
Basically, you should always consider potential loss. You can lose money on an investment that should have been safe, such as diversified stocks and even bond ETFs. This is known as market risk (systematic risk), which means that your investment may fall in value if the market falls. As an investor, you have no control over this. The price movement of the stock market is determined in the long term by macroeconomic and political developments.
Simple example: suppose you buy a lower-risk ETF that provides global diversification (see examples below). In this case, you are betting money on the global economy. The assumption is that the world economy will continue to rise in the long run. If this assumption is correct, you will make positive returns with ETF investing over the long term.
However, this assumption does not have to be true. This is especially true for themed ETFs that focus on one sector or one country. In this case, you are left with little or even negative returns (even with dividends). There are plenty of examples of this, such as AEX and Japan index funds.
Theme ETFs therefore always have higher risk than global ETFs.
But even a global ETF can realize negative returns in the short, and even long, term. If there is economic contraction at the global level, such as a global financial crisis or major wars, this will have a negative impact on stock prices in the short term.
Don't think you'll always make a profit! This is a big mistake. You always need a good investment strategy.
Other risks of ETF
Market risk cannot be influenced. This is the price we pay to join the game. This is why investing always has risks.
In addition, an ETF has other risks. The degree depends on the type. There are several types. With a perfectly diversified investment portfolio, you can minimize other risks, leaving only market risk (and possibly currency risk).
But we humans are not perfect.
And besides, the fun part of this game is to strive for higher than average returns. This only works if we take on more risk. Like with the potentially best ETF, but certainly also if we choose individual stocks. And if we go down this path, there are several risks involved.
Below is an overview of risks in ETFs (not exclusively to):
- Currency risk: difference between currencies over time
- Interest rate risk: bonds and certain stocks perform poorly when interest rates are rising
- Volatility risk: emotional panic selling when prices fall sharply
- Counterparty risk: if a party fails to deliver what it promises
- Trackerror: the ETF fails to track the underlying index accurately
- Geographical distribution: ETF targets limited geography
- Sector spread: specialist ETFs that focus on one sector can also go into decline, resulting in disastrous losses
- Liquidity: not all trackers are equally liquid
- Leverage: certain ETFs work with leverage (levers) which can lead to massive losses
Let's look at examples of high vs. low risk ETFs.
Examples of ETFs with high risk
There are many ETFs that have a high risk. Here are some examples of ETFs with high risk:
Example high risk ETF: ARK funds
The ARK Innovation ETF (ARKK) is a risky investment with the potential for capital loss. The fund invests primarily in risky growth stocks. Although these are well-known names, such as Shopify and Square, these types of stocks offer much more risk to loss.
The fund is also not very diversified, meaning it concentrates its portfolio into fewer individual holdings than a diversified fund or index. The tracker follows about 35 to 55 companies. And these are all risky growth stocks. In that respect, ARK definitely belongs to a high-risk ETF.
Why is this risky?
Because these companies are often small cap stocks and/or have limited history, they can be volatile. In addition, many of these companies have no earnings history. This makes it difficult for analysts to accurately predict their stock prices, making ARK Innovation ETF a risky investment for people who do not have a thorough knowledge of investments or who are uncomfortable with taking on risk.
As of its peak in 2021, the fund is down 75%(!).
So why invest in a high-risk ETF like ARK? Because these types of themed ETFs may well realize high returns in the long run. But the timing of entry is very important and should always be at times of acceptable financial (under)valuation.
Example high risk ETF: TQQQ
TQQQ is a high risk ETF that puts leverage 1 : 3 on QQQ. QQQ is a tracker for 100 innovative companies. And TQQQ uses and leverage to triple returns. Leveraged. But TQQ is a complex product. While TQQ can generate a lot of profits when the right entry point is used, it can also generate huge losses. Even when the Nasdaq remains flat.
Leveraged funds like TQQQ can have extreme price swings, making this ETF too risky for investors who have a low volatility tolerance.
In addition to the risk that performance may not meet expectations, leveraged ETFs also charge a higher management fee to absorb the costs of leverage and actively rebalancing their funds. Most ETFs have expense ratios of less than 0.20%, while TQQQ's fee is 0.95%, or $95 for every $10,000 invested.
Back tests show that TQQQ can be held for a longer term (1 year) and beats QQQ, but holding for too long (5 years) can significantly degrade performance. Holding TQQ for too long almost guarantees that you will face a long-term down market that wipes out almost your entire portfolio.
Simple example: if in those 5 years one bearmarket occurs where QQQ goes -33%, then from that moment on TQQQ stands -99%. And from that moment on it is almost impossible to get your initial deposit back (for that you need x100 return).
Example high risk ETF: Direxion Daily Small Cap Bull x3
Direxion Daily Small Cap Bull 3X Shares (TNA) is a final example of high risk ETF. This tracker also uses a leverage of x3. In addition, the cost is very high at 1.12 percent.
This fund is designed to offer investors three times the daily performance of the Russell 2000 Index, which measures the performance of small cap stocks. This means it is more likely to lose money if the market falls. Because the fund invests in small companies, it can also be more volatile than other investments.
A simple example: in 2018, the fund was down -60%. In 2020, during the covid-19 crisis, the fund fell by -85%, and in 2022 the fund will fall by at least -65%.
The entry point into high risk ETFs is of great importance. In theory, the tactic is simple: get in after a major stock market crash and sell within 12 - 18 months once the stock market has recovered. In practice, however, this is difficult. No one can time the market exactly. And how do you react when the tracker drops further by another -80%?
The novice investor is better off focusing on a lower risk ETF. And low-risk investing in general.
Examples of ETFs with lower risk
There are also many ETFs that have a low risk. Here are some examples of ETFs with lower risk:
Example lower risk ETF: Vanguard Total World Stock Index ETF (VT)
Vanguard Total World Stock Index offers unrivaled diversification. This comprehensive portfolio holds a piece of every investable stock in the world and marries it to a low fee. These features should make it tough to beat over the long run.
This fund tracks the FTSE Global All-Cap Index, which includes stocks of all sizes listed in developed and emerging markets. The Vanguard Total World Stock Index ETF has a lower risk profile than most other funds because it is diversified across many different countries and regions.
Broad diversification mitigates the impact of the worst performers on the fund’s overall performance. The index includes more than 9,000 stocks, and the managers almost fully replicate the benchmark. Its 10 largest names account for only 15% of its assets, making it one of the least concentrated portfolios.
The fund’s low fee has translated into solid performance. The Admiral and exchange-traded share classes both beat the category average by 1.1 percentage points annualized over the trailing 10 years through December 2021. Most of that advantage came from the ultralow expense ratios attached to each share class. Rock-bottom fees should continue to give this fund a long-term edge.
This fund also has low volatility compared to other funds. This means that it doesn't swing wildly up or down in price over short periods of time but remains steady throughout long periods of time.
As an investor, you can only have two criticisms of VT, namely: (1) the fund is too diversified and (2) as a result, realizes lower returns than, say, the S&P 500 (over the long term).
A passive investor can supplement VT with the best dividend ETFs that generates more passive income.
Example lower risk ETF: Vanguard All-World ETF (VWRL)
Vanguard All-World ETF is a fund that invests in a globally diversified portfolio of stocks, bonds, and short-term investments. It is designed to support long-term growth of your money while keeping your risk low.
Vanguard All-World ETF is an excellent choice for investors seeking a low-risk, diversified investment. It focuses on small and mid-sized companies, which makes it a good choice for those who want to spread their risk over a wide range of stocks, rather than focusing on just one or two big ones. This helps to keep the fund's performance high while reducing risk overall.
It offers a lower cost alternative to actively managed funds, which are often higher priced because they require more active management and research.
By investing in this fund, you will be able to reduce your risk and maximize your return by investing in international companies. There is no need to worry about any one company's performance because the fund invests in many different companies from around the world.
Where to buy ETF’s?
It is important to choose the best investment platforms. They offer a wide range of ETFs so that you can build a good portfolio. They also have low transaction costs. Some even offer commission-free investing. In the long run, this saves a lot of costs.