Your Exchange-Traded Fund (ETF) Is Riskier Than You Think

Exchanged-traded funds (ETFs) are the go-to investment for more investors. Ten years ago, ETFs attracted $230 billion of investor funds. Today, they attract more than $2 trillion. An ETF (1,400 in all) exists for nearly every asset class and most investing strategies (long, short, leveraged, etc.).

The attraction is understandable. The ETF structure appears to reduce risk. ETFs are similar to mutual funds. They hold a group of assets, thus they are diversified. Unlike a mutual fund, though, ETFs are actively traded during market hours. In addition, ETFs are constructed to trade at par with the underlying assets (or benchmark index).
ETFs appear to be the perfect investment: They offer diversification and market, sector, or industry exposure in one tradable security.
But appearances are deceptive; perfection is not of this world.
Once again, we confront the elusive free lunch: ETFs come saddled with annual fees. The average ETF charges 44 basis points annually. Admittedly, that’s not much, but it’s still $44 annually on a $10,000 investment. You buy four of the top stocks in the ETF’s portfolio and you’ll pay less than $40. What’s more, you’ll pay only once if you buy and hold.
If an ETF performs as advertised, fees are a secondary annoyance. The risk, and therefore the primary annoyance, is that an ETF won’t perform as advertised. Investors painfully learned that ETFs don’t always perform as advertised.
On Aug. 24, The Wall Street Journal reported on a major disconnect between a popular ETF, the iShares Select Dividend ETF (NYSE: DVY), and its underlying components. In early trading, DVY shares tumbled 35%, while the combined weighted value of its underlying stocks – mostly large-cap dividend stocks – were down 2.7%. Had you placed an untimely order to sell at the market price that fateful day, you could have lost two years of return in a split-second.
Yes, the 35% discount was a fleeting anomaly, but DVY shares were still down over 8% in early trading. This was still a meaningful discount to the 2.7% decline in portfolio value.
Therefore, the overarching concern is that volatility spikes when you least want it – during market turmoil. ETFs are more diversified than a single stock, so you’d expect less volatility when all hell breaks loose. Unfortunately, the mechanism to maintain ETF price parity with the underlying holdings is vulnerable, as trading on Aug. 24 attests.
ETFs are designed to maintain price parity with the underlying holdings through arbitrage. Traders buy and sell the ETF and its underlying components to exploit price discrepancies between the two. This trading activity keeps the ETF price near the market value of its underlying component assets and enables all-day trading.
Recent trading activity reveals this equalizing mechanism is imperfect. Liquidity can evaporate and the ETF can disconnect from its underlying portfolio. Of course, this all occurs when liquidity and equilibrium are most valued – during a market sell-off.
This isn’t to say investors should eschew all ETFs. They can be a worthwhile vehicle for individual investors. They are diversified and they allow efficient access to less-liquid investments – commodities, corporate bonds, and preferred stocks.
For stocks, I still favor individual selection. Low cost – $5 to $10 for a one-way trade – gets you in.  With 15 stocks you can construct a diversified portfolio, and you can tilt that portfolio toward the sector of your choice. At the same time, you get diversification and can get the performance of a broad-based or a sector-based ETF.
ETFs have their place, but don’t forget that individual stocks have theirs as well.
For details on some of the strongest, safest individual stocks worth owning, click here.