The risky side of ETFs

ETF, exchange traded fund, Organic Financial Group, Gary Norden, index fund, investment advice, financial literacy, financial education, portfolio construction, portfolio diversification,

Exchange traded funds, or ETFs as they’re more commonly known, are becoming increasingly popular among SMSF trustees and investors looking to diversify, but financial consultancy Organic Financial Group cautions these products can have “significant weaknesses”.

Speaking to Nest Egg’s sister site InvestorDaily, Organic Financial Group’s founder Gary Norden said ETFs have “never been tested in a difficult environment”, and changes in the market environment could have serious implications for ETF investors.

“The last few years have been very benign for markets, and we know from people were talking to in the industry ... a lot of the testing of these products is really going on in that benign market,” Mr Norden said.

“You could have ETFs on the S&P 500 that are constructed completely differently. Weve seen that, we’ve seen some that are constructed with an almost opposite view to another one. Those kinds of things we find interesting because they open up vulnerabilities.”

One reason this can happen, Mr Norden said, is because some ETF providers “make short cuts” in order to offer a low-cost product.

“For example, ETFs on S&P 500 in the US, many of them will not absolutely buy the 500 stocks and weight them as they should be in the S&P 500,” he said.

“Different styles of ETF are constructing their portfolios to mirror the S&P 500 in different ways. The people buying those ETFs are probably not aware of that theyre buying an S&P 500 ETF. Its mirroring the returns, but people think theyre matching the market.”

This isn’t to say ETFs are risky products or they don’t have benefits. They have a number of benefits, but many investors aren’t thinking deeply [about] the structure and risks associated with the product, Mr Norden said.

“Any market that grows as large as quickly as the ETF market has should be constantly tested, but its hard because the industry generates a lot of revenue,” he said.

“Its important that when people look at the benefits of ETFs, and there are benefits, but you’ve got to be looking at the long-term sustainability of the product – does it work in every market condition? How does it react?”

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