Passive funds are growing in popularity. This week Tim Bennett explain why and points out five pitfalls that investors should avoid.

Five hidden risks with exchange traded funds

Passive investing is on something of a roll, with the number of exchange-traded funds (ETFs) surging in recent years. This is due in large part to the investor-friendly features that passive funds can offer;

However, for investors, the challenge is to separate the increasing about of good wheat from the chaff that now accompanies it as more and more similar-sounding products hit the markets. Here are five things to think about before taking the plunge.

Market risk

In a bull market, passive funds can seem like a no-brainer as they dutifully track any rise in the market. The problem is that in a flat, or bear, market they also faithfully copy the underlying index or product, leaving investors with no downside risk management mechanism.

Too much choice

It used to be easy. In the early days there were few ETFs to choose from and in many ways, this made things simpler for investors. Now there are multiple versions of similar products, all with differing underlying structures and fees. Screening is therefore increasingly important.

Not so simple

ETFs are billed as being simple and cheap. The problem is that more and more products are being launched that are not – a 2 x inverse derivative-backed ETF anyone? Whilst more complicated ETFs can have their place in some portfolios, investors need to understand what is under the bonnet before buying.

Liquidity risk

Many ETFs are straightforward to buy and sell. However some may not be if market conditions suddenly deteriorate. A bond-backed ETF, for example, may suddenly suffer sharp price falls and very wide spreads if the underlying bonds become hard to sell. The ensuing investor panic could make the situation even worse in the short-term.

Behavioural risk

The problem with creating a product that is fast and simple to buy and sell is that investors may, ironically, then trade it too often just because they can. The decision to buy a passive fund requires as much judgement as any other investment decision – ETFs are not a substitute for proper investment planning and subsequent investor discipline.

Conclusion

Chosen well, ETFs have a place in many portfolios. However, investors should not regard them as a panacea that removes all thought from the investment process. In short, all investment and asset allocation decisions require judgement – in that sense the expression “passive investing” should be treated with due caution!