Quora Answer: What are the Considerations for Investing in ETFs?

The following is my answer to a Quora question: “What are the Considerations for Investing in ETFs?”

Exchange-traded funds are investment funds traded on stock exchanges, similar to stocks.  However, an ETF may hold a variety of assets from stocks, to bonds, operating through arbitrage.  Since the vast majority of ETFs track an index, they are attractive due to their lower transaction and management costs as well, and liquidity. ETFs are also good for their tax efficiency in places where there is a capital gains tax.  They are less attractive in place which do not have such a tax.

However, when investing in ETFs, it is important to understand how they track the index, and if there is any variation of this replication due to specific strategies.  Otherwise, you may have tracking errors, where the ETF begins to diverge greatly from the index it is supposedly tracking.  This sort of volatility may be unacceptable to you, if you are leveraged, or otherwise have a lower risk tolerance.

ETFs that are based on commodities and futures contracts are actually more volatile than they appear because the leverage is embedded due to the nature of the underlying asset.  That means, should there be a precipitous decline in the equity markets, or a protracted period of decline, your ETF will be significantly affected.  I would recommend not loading your portfolio with too much of these ETFs.

Another point of consideration is that ETFs are still relatively new, and lack transparency.  It is only a matter of time that central banks start to impose more stringent regulations, which is, in itself, not a bad thing.  However, in the interim, this would affect market confidence in ETFs, and their price.  Also, every time a new compliance regime is imposed, the implementation costs are significant.  This regulatory risk is something any savvy investor would be paying attention to.  This would also address the inherent counterparty risk, since the contracted counterparty is legally obligated to match the return on the index.  Should they fail, there will be a cascading effect on the price of ETFs, and severely affect the secondary market.

In summary, ETFs are good, they are exciting, they are a viable option.  But they are no different from any other asset class in that they have their unique risk which must be considered.  I would recommend buying them.  I would never recommend loading your portfolio with them only.  A good portfolio is diversified across asset classes and balanced.