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Understanding the Risks

When considering an ETF as an investment, as with any other investment vehicle, risk will be involved. As with all types of investing, it is wise to read the prospectus and information materials, and seek the advice of an investment professional prior to making investment decisions. Here are some questions you may wish to ask yourself when considering if ETF investing is right for you.

What market does the ETF invest in and what market is covered by the benchmark index? As with other types of investments, investors should consider the underlying index or benchmark of the ETF and how it fits with their investment objectives and investor profile. Conservative investors may wish to look for an ETF that covers a solid, established market or benchmark, rather than a speculative or emerging benchmark. If you are interested in investing in certain sectors, asset classes, commodities or types of securities through ETFs, you should be aware of the market cycles and risk factors related to that area of the market. ETFs will mirror the underlying market fluctuation of the types of investments they hold.

Do I understand what the underlying investment of the ETF is? Take the time to do your research and look at the benchmark that the ETF follows, including the individual constituent stocks, bonds, commodities or other securities that make up that benchmark. Ensure you are comfortable with the underlying investments, and that their weighting in the ETF matches your investment strategy and values.

Is the ETF leveraged? If so, you should be aware that, while your returns may be magnified when the investment goes up, your losses will conversely be magnified when the investment goes down, and that with some leveraged ETFs this loss will be compounded if your holdings are not rebalanced correspondingly on a daily basis. You should read the prospectus and other information materials for the ETF carefully in order to ensure you understand the type of leverage the ETF uses, and how it is used. Leveraged ETFs will also tend to have more price volatility. As a general rule, if you do not actively manage your portfolio on a daily basis, or if you do not understand the concepts of leverage and daily rebalancing, these ETFs are not a good choice for you. Leveraged ETFs are not suitable for investors who are looking for investments which they plan to buy and hold for a long period of time.

Is the ETF consistently trading or does it have thin trading? ETFs that trade steady volumes every day will be more liquid than those that don't trade a lot of volume. Some ETFs, such as those that are leveraged, may have a high volume due to the fact that they are traded with a daily return in mind, and thus investors may buy and sell these particular ETFs very often.

Do you understand the concept of a tracking error? A tracking error is inherent in all ETF investments. A tracking error is the difference between the total Net Asset Value of the underlying assets that comprise the ETF, and the prevailing share price of the ETF. There is always a difference between the two - usually the difference is negligible, but you should check whether the ETF you are interested in has a significant tracking error.

How does this ETF fit into my overall portfolio strategy? If your portfolio is already heavily weighted in a certain sector, commodity or market, an ETF that adds to the weighting may not be the right choice for you. It may seem like a good idea to overweight in a particular area of the market that seems to be popular and rising, but the corresponding risk is that you will lose more if that area of the market declines. ETFs should be used as one tool in a balanced, diversified portfolio strategy, where you pick a mix of investments that spread over a wide set of markets, sectors, asset classes, commodities and types of investments (equities, fixed income, cash and derivatives), so as to minimize the risk of overweighting your exposure in a certain area and increasing the risk of your portfolio. The type of ETF should also be considered in the context of the risk profile of your overall portfolio.