Types of ETF Risks

Counterparty Risks

An investor’s principal can be put at risk by over-dependence on a counterparty. Moreover, the economic exposure of the fund can also be affected by counterparty failures. Therefore, investors are advised to evaluate the underlying counterparty risks when entering an ETF. Examples of counterparty risks are settlement risks and security lending.

• Settlement risk: This is common in ETFs that use over-the-counter derivatives. It implies the losses incurred due to counterparty risks. Settlement risks can be managed by settling over-the-counter contracts frequently to minimize exposures to swap partners in case of bankruptcy.
• Security lending: Sometimes, ETF managers lend their securities to borrowers (short-sellers), with that security being replaced later by a purchase. The fund is at risk if the borrower fails to meet the obligation. Therefore, to reduce this counterparty risk, over-collateralization of the lent securities must be done.

Fund Closures

ETFs, just like any other fund, may close. The underlying securities of the fund are sold, and then cash returns are made to the investors. Fund closures can be a result of regulations governing the funds, competition, corporate actions, creation of halts, and change in investment strategy.

• Fund regulations: Changes in the standards governing ETFs might result in the failure of funds. For instance, a sudden increase in interest rates can jeopardize the fund’s operation, causing closure.
• Competition: With the rapidly rising number of ETFs, competition has also increased. Although investors have profited from it, many funds with smaller trading volumes are closed due to their inadequate attractiveness.
• Corporate actions: These closures result from merging and acquisitions from one ETF provider to another. In case ETFs are sold, their new owners may decide to seize the huge growth opportunities, thus shutting down the underperformers.
• Creation halts: There are cases where a fund suspends selling from its inventory hence freezing further creation and redemption of shares. In such cases, as the hedging mechanism collapses, the fund will trade at a premium against the fair price. This situation is very common for exchange-traded notes (ETNs).
• Change in investment strategy: Sometimes, rather than closing a fund and opening another one, ETF managers can change that underlying index of the fund. Although this might seem easier, it can cause virtual closures.

Investor-related Risk

Investors who do not understand the ETF’s inherent exposures and performance are likely to be at risk. Therefore, investors must evaluate the fund’s index methodology, as well as its portfolio construction approach. Investors who are most susceptible to this risk are the leveraged and inverse exchange-traded funds.

The leveraged products must reset their exposures daily to attain the expected return multiple for each day.

Example: Levered 3 times ETF Exposure

An ETF offers a 300% exposure to the S&P 500 Index with a net asset value of $150 and a notional exposure of $200. The one-day S&P 500 Index return is 10%. The ETF’s exposure and end-of-day net asset value are closest to:

Solution

Exposure to index = 3 times

Index return = 10%

$$ \text{Exposure} = $200+\left($200\times10\%\right)=$220 $$

$$ \text{End-of-day NAV}= ($150\times\left(1+3\times10\%\right)=$195 $$

Therefore, attaining 300% of the index’s daily performance for the next day requires a notional value exposure of \(($195\times3)\). The ETF must reset its exposure since there is only $220 in exposure. Therefore, the notional swap exposure is increased by \($585-$220=$365\).

Question

Consider an ETF that offers a 300% exposure to the benchmark index with a net asset value of $125 and a notional exposure of $140. The one-day S&P 500 Index return is 6%. The increase in the notional swap exposure is closest to:

1. $442.50.
2. $294.10.
3. $295.90.

Solution

The correct answer is B.

Exposure to index= 3 times

Index return = 6%

$$ \text{Exposure} = $140+\left($140\times6\%\right)=$148.40 $$

$$ \text{End-of-day NAV}= ($125\times\left(1+3\times6\%\right)=$147.50 $$

The required notional value to attain 300% exposure for the next day is \(\left($147.50\times3\right)=$442.50\).

The notional swap exposure is thus increased by \($442.50-$148.40=$294.10\).

Reading 39: Exchange Traded-Funds, Mechanics and Applications

LOS 39 (g) Describe types of ETF risk.