Exchange-traded Funds Risks

The Associated Risks of Exchange-traded Funds to Be Wary Of

The following article, describes some of the key risks which may be faced while investing and trading the exchange traded funds. A brief explanation of the mechanism of the fund has also been explained in the following paragraphs.
An exchange-traded mutual fund operates primarily like a mutual fund and also works in almost the same manner as common mutual funds. There are however, several unique features of this sort of mutual fund, because the best merit about it is that it is traded on a stock exchange. Apart from that, another specialty of this fund is that, it tracks certain stock market indexes such as the S&P 500. It means that this investment option is an investment fund, or either way its asset value is decided by the performance of the index or the demand for the said fund's shares. Here's a more simplified and comprehensive elaboration of the concept and also some of the prominent exchange-traded funds.

Definition of Exchange Traded Funds

Exchange-traded Funds (ETF) are chiefly the funds which contain the pooled out money of several different investors. The pooled money is invested into sources of investment such as the stock and money market by the fund providing company. The contribution of these investors is noted as a 'share' of the mutual fund, and it must be noted that the financial net worth of each share at any given point of time is congruent to that of the others. The market price of these shares initially is small, however as the performance of the fund differs/rises the market price of the shares goes on increasing. In a contrast situation when fund does not perform, the share value may demote.

Another feature of the exchange-traded fund that makes it an 'index fund' is that it tracks or rather literally imitates certain official indexes such as the ones of New York Stock Exchange or NASDAQ. Apart from that such funds also imitate some other private indexes such as the S&P or the Dow Jones Index. By tracking or following the index, the portfolio of the fund actually operates as per the graph of the index, unlike the other funds which are controlled and portfolios which are operated based upon the assessments and investing strategies of a fund manager. In recent years (post the 2008), the United States Securities Exchange Commission has also authorized the creation of Exchange-traded funds which are managed by fund managers. The trading of shares of exchange-traded funds is same as the common stock, all you need to do is have an account with a broker who trades in them. In a nut shell, an exchange-traded fund is a mutual fund which is traded in a stock exchange by the way of 'shares'.

Exchange Traded Funds Risks

Investing and trading in the mutual funds is not exactly what one might call as full proof and risk free, though there are no security concerns, there are some risks which can lead to some loss...

1. Economic Dip
The first and probably also the worst risk of investing and trading in an ETF is that since it follows a certain index or a set of indexes, it is directly affected by the performance of the economy and thereby, the index which it tracks. The problem however is partially overcome by the professionally managed ETFs which would not be directly affected by the ups and downs in the economy.
Solution: If you are planning upon investing and trading index ETFs then one of the best ways is to withdraw all your investments from the markets as soon as the economy starts tilting. The effect is that you earn a lower profit than expected, but at least you don't lose any money.

2. Derivative Based Portfolios
Often the exchange-traded funds place their finances in the certain derivatives which are chiefly contracts, which are highly speculative in nature.This substantially increases your risk of losing market value of the share of the fund. Apart from that, the derivative contracts often increase the risk of losses, after all we can't predict the future, can we?
Solution: Find ETFs with less speculative portfolios or who have lesser derivatives or have derivatives in several different sectors.

3. Sectoral Losses
Often there are ETFs which invest in lesser number of sectors or lesser versatile sectors. On the whole, when it comes to all funds and especially the ETFs, the saying, don't put all your eggs in a single basket, applies. The problem is the ETFs which invest their funds into a restricted or small number of sectors, face a substantial risk of losses, in case, if one sector goes into very sudden depression, recession or loss cycle. This will also pull down the market value of your share of the fund.
Solution: Invest into a fund that depicts a wide or versatile portfolio covering the key sectors of the economy.

4. Speculative Mountains
The money that is investing into the ETF's shares is further invested into the stock and money market investments, upon which the entire fund works. The big risk is that investors of the ETF becomes subject to all speculative mountains. It often happens that for a certain quarter of a year a sector performs brilliantly, upon which the stock investors, all investing firms and companies turn their attention and investing focus on to that sector. Upon this higher demand the value of stocks and indexes associated with this sectors substantially shoot up, leading to the appearance of a small mountain on the graph of the market value of stock and also the values of your share holdings in the fund. This steep mountain eventually leads to a drop in the graph and there is a good chance that your fund has taken a toll in the process. In such a case the accompanying side effect is that the share value of the fund and also the dividends drop down.
Solution: If such a speculative mountain is seen, based upon your personal assessment you can sell off the share at a break even price plus some profit. At least you can make some money in the unnecessary speculation.

5. Uneven and Low Returns
There are certain moments when we feel like tearing out our own hair in anger and frustration. This may happen when the total rate of return (total amount of sale of fund share + total dividends - total amount invested, converted into percentage and divided by the number of years) tends to be so less than even a simple bank account. This can indeed happen as the fund is based upon an index, the performance of which is not within your reach or control.
Solution: Actually there is nothing much you can do about it, and the only solution is that if you see the performance of the fund dwindle, the best thing that you can do about it is to sell off the share once it hits the break even points.

While, investing in exchange-traded funds, you may as well encounter one or all the aforementioned risks, and even some newer and unique ones. Often acknowledging the risk, studying it and acting on it pays off very well as you can curtail the loss altogether, the key is to patiently watch the ball and think about it.
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