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Are Your ETF Investments at Risk in a Market Sell-Off?

Arguments about whether exchange-traded funds carry extra risk in a market crash are worth considering, but long-term investors with diversified portfolios don’t need to worry.
March 14, 2018
Investing, Investing Strategy, Investments
Are Your ETF Investments at Risk in a Market Sell-Off?
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To say exchange-traded funds are enjoying a moment right now is an understatement — they’re the darlings of the investing world. In the first two months of 2018, new funds launched at a pace faster than one per day. And a recent survey conducted by BlackRock found that 62% of investors planned to buy an ETF in the next 12 months.

Despite their popularity — or perhaps because of it — ETFs have attracted detractors. These assets, which track an index of securities much like a mutual fund and trade like stocks, are by no means new: The first ETF debuted in the U.S. 25 years ago. But there’s still skepticism about how safe they are, especially when the market crashes. (It’s been a while since this happened, but here’s what you need to know about a stock market crash.)

The idea that ETFs will be riskier during a sell-off is typically bandied about by mutual fund managers, who pick individual stocks, a task at odds with the passive nature of ETFs. Suffice it to say, some ETF detractors may have a personal incentive to steer investors away from these assets.

Still, the notion that your ETF holdings may be riskier than you realize is worth exploring, not least because this idea surfaces in the financial media regularly. Here’s a look at the two main arguments — and what you need to know about ETF risks in general.

1. ETFs are ‘untested’

The argument: ETFs have exploded in popularity since the financial crisis that began in 2007 and sent the Standard & Poor’s 500 index into a bear market. (A bear market is a period when losses surpass 20% from the market’s most recent high.) The ETF market of today hasn’t experienced a market crash and could be vulnerable in the next one.

The reality: The part about ETFs growing in popularity is true: As of January, more than $3.5 trillion was invested in ETF assets in the U.S., up from $498 billion in 2008, according to data compiled by research firm ETFGI. That sevenfold increase supports the argument that many more people are invested in ETFs now than a decade ago.

As for being untested, well, not so much. While the growth in ETF assets has coincided with the current bull-market cycle, there have been opportunities for ETFs to be tested even if the market hasn’t succumbed to a prolonged sell-off.

There have been opportunities for ETFs to be tested even if the market hasn’t succumbed to a prolonged sell-off.

Most notable were a couple of “flash crashes” — one in May 2010, the other in August 2015 — when the market fell sharply and quickly and ETF prices weren’t trading in lockstep with their underlying assets, as they’re supposed to do.

Since the 2015 flash crash, however, the industry has made a lot of changes — including shoring up trading technology and changing some rules and regulations — to prevent this from happening again, says Martin Small, managing director and head of BlackRock’s U.S. iShares, the largest ETF provider. Proof that those changes have worked came in February when the S&P 500 fell 4.1% and 3.8% on two separate days.

Even amid “some of the most large-scale market gyrations, there was seamless ETF trading,” Small says. Those were just the latest examples, he says, pointing to other volatile days in the market — such as the surprise Brexit vote or U.S. election, both in 2016 — when ETFs performed as intended.

2. ETFs are less liquid than you think

The argument: Investors have a false sense of security in the liquidity of their ETF investments, or how easy they’ll be to sell when the time comes. This could be problematic when a lot of investors are trying to sell at once.

The reality: There’s some truth here, especially because ETFs aren’t all created alike. To assess the liquidity of your current (or potential) ETF holdings, review the fund’s average trading volume and assets so that you pick the right ETF. Liquidity can be a problem for small or niche ETFs, but not for the largest ETFs — many of which track major indexes like the S&P 500 — because these funds have average daily trading volume in the millions.

The risk here may be the investor’s impulse to sell, rather than the ETF. “One of the biggest risks that people face with ETFs, ironically, is themselves and their own ability to transact,” says Greg King, founder and CEO of REX Shares, a Westport, Connecticut, company that creates exchange-traded products.

Trying to sell when the market is moving sharply isn’t advisable for long-term investors. That’s because such investors should be invested in shares they believe have value over the long haul, and short-term price movements — even dramatic ones — shouldn’t cause them to sell in a panic.

One of the biggest risks that people face with ETFs, ironically, is themselves and their own ability to transact

Greg King, founder and CEO of REX shares

On the other hand, if you’re a short-term trader, take steps to combat any liquidity issues when the market is swinging wildly. Specifically, use a limit order rather than a market order, King advises.

A limit order is an instruction to sell only at a specific price (or better), whereas a market order is executed ASAP. “Always use limit orders because market orders are potentially problematic in a fast-moving market,” King says. (New to order types? Learn more about them in our guide to buying stocks.)

As Small puts it: “Friends don’t let friends place market orders.”

ETFs and long-term strategies

Fretting about how ETFs will fare in a market downturn (spoiler alert, they’ll most likely go down in value) isn’t fruitful, especially if these assets are part of a long-term investment strategy.

Just because you can trade an ETF regularly doesn’t mean you should.

But like any investment, ETFs aren’t risk-free. Two types of ETFs are inherently risky, so long-term investors should steer clear. Leveraged ETFs are designed to amplify returns (but they also amplify potential losses), while inverse ETFs are designed to profit when the underlying benchmark declines in value (but create unlimited risk if the opposite happens).

When considering ETFs, it’s important to understand what you own — and why. While the number of ETFs available for investment continues to expand, simple portfolios consisting of a handful of funds can help you achieve your retirement goals.

Finally, just because you can trade an ETF regularly doesn’t mean you should. These investments can, and should, be a part of a long-term investment strategy.

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