The Do's & Don'ts: ETF Grades

By Yash

The last few years have been a wild ride for ETFs, with new products and providers entering the market and regulators worldwide taking note. But increased regulatory scrutiny has also led to some issues that have prompted many institutions and advisors to pause before adopting these funds. As a result, the adoption of exchange-traded products has slowed down in recent years. In light of this trend, advisors need to understand the risks associated with ETFs before deciding to adopt them as part of a client's portfolio. While ETFs are often viewed as being risk-free due to their passive nature, this is not entirely true. The risk level associated with ETFs largely depends on the type of asset they are investing in. For example, while most conventional (non- actively-managed) ETFs are generally considered to be risk-free due to their passive investment approach, actively-managed ETFs may be riskier due to their active investment approach. Additionally, exchange-traded notes (ETNs) are a type of closed-end fund that is riskier than ETFs due to their reliance on debt rather than equity.

To help you get started, we’ve put together a list of things you should know about ETFs if you’re ready to adopt them as part of your investment strategy.


1. Don’t Forget To Do Your Due Diligence


A lot of the issues investors have with ETFs are the result of a lack of due diligence. Make sure you know what you’re buying when you add ETFs to your client’s portfolio and don’t just assume they’re fine because they’re ETFs. Unlike mutual funds, which are required to disclose all holdings, fees, and other important information in a prospectus, there is no such requirement for ETFs. That makes it even more important for you to research ETFs thoroughly before recommending them to clients.

There are plenty of high-quality ETFs available, but you need to know how to identify the riskier ones that may not be suitable for all investors. The first thing to look at when you’re considering an ETF as an investment option is its expense ratio. Expenses are what eat up the majority of returns, so you want to make sure you’re choosing an ETF with a low expense ratio. You can find an ETF’s expense ratio by checking its website or FINRA’s website for its prospectus. Expenses can vary widely, so you want to make sure you’re choosing an ETF with a low expense ratio.


2. Know The Risks Before You Buy


Although ETFs are a suitable investment vehicle for a variety of investment strategies, the risks of using them must be thoroughly understood by those considering their use. As with any type of investment, there are risks associated with the use of ETFs. Some of these risks are unique to ETFs, while others are common to all types of securities, including mutual funds. The following are risks that you should be aware of before you decide to use ETFs in your clients’ portfolios: There are also a few other issues to keep in mind when using ETFs in your clients’ portfolios. These include the fact that the prices of ETFs may not reflect the full value of their underlying holdings and the fact that there is no guarantee that an ETF’s sponsor will be able to pay out profits as expected.

Investors who want to minimize these risks can look for ETFs with low expense ratios, diversified holdings, and a track record of steadily increasing dividends. These factors can help reduce the risk of investing in ETFs, but they do not eliminate it. No investment is risk-free. However, by diversifying their portfolios and considering the risk factors associated with individual ETFs, investors can improve their odds of achieving their goals.


3. Fees Matter


Even though ETFs are generally cheaper than actively managed funds, they still need to be monitored for excessive fees. One way to do this is by checking the expense ratio. This is the percentage of each client’s investment that will be spent on fees. The average expense ratio for actively managed funds is around 1.2%, while the average expense ratio for an ETF is around 0.5%. There are, however, ETFs with much higher expense ratios as well. You should only adopt ETFs with expense ratios that are as low as possible. There are a few things you can do to reduce the impact of fees on your clients’ portfolios, including minimizing trade frequency, increasing portfolio diversification, and minimizing the use of short-term trading strategies.

These are all important aspects of maintaining a healthy investment strategy, but reducing or avoiding fees entirely might be even more important for some investors. If you have a large account and significant assets, you might be able to negotiate lower trading rates with your brokerage. You may also be able to work with your financial advisor to find ways to minimize or avoid advisor fees.


4. Be Wary Of Leveraged ETFs


Leveraged ETFs are a type of ETF that uses derivatives and cash to add additional investment exposure beyond what can be achieved through a conventional portfolio of stocks. These ETFs are designed to be held for a very short period, and should not be held for long periods in a portfolio for two reasons. First, if held for long periods, there is an increased risk of unexpected loss due to volatility-induced drag on the portfolio value. Second, the additional fees associated with holding leveraged ETFs for long periods may negate any benefits of portfolio diversification.


5. Stay On Top of Proprietary Language


It’s important to take a close look at the language in the prospectus of any ETF you’re considering adding to your client's portfolios. You should be looking for anything that might cause a problem, no matter how minor it may seem. Some of the language you might want to be wary of includes words like “may,” “might,” “could,” and “potential.” These words indicate that the fund sponsor is not making any promises. Be especially wary of language containing “not guaranteed.” This language indicates that the fund sponsor is not making a promise that they will be able to pay investors a specific amount at a specific time.


6. Don’t Assume Inclusion Means Safety


Just because an ETF is listed on a major exchange does not mean that it is a safe investment. You should do all you can to make sure that the ETFs you recommend to clients are held by a trustworthy fund sponsor. Avoid recommending ETFs that are held by a company with a history of questionable business practices. You can minimize the risk of putting your clients in a situation where they are exposed to a less than trustworthy ETF sponsor by doing your research. Stay up to date on the latest news and developments that might affect the reputation of the companies that sponsor the ETFs you recommend. Many ETFs are issued by smaller, less-known fund sponsors, and some of these smaller fund sponsors have questionable track records. You should only recommend ETFs from fund sponsors that you know and trust.


Bottom Line


Overall, exchange-traded funds are a valuable tool for investors and advisors. They’re a cost-effective way of accessing various asset classes, they can be used to implement a variety of investment strategies, and they provide investors with many different types of risk and return profiles. Keep in mind, though, that just because ETFs are low-cost and easy to use, they aren’t a one-size-fits-all solution. You need to be sure that the ETFs you recommend to clients fit their risk tolerance, investment objectives, and financial situation.

This is especially important when it comes to ETFs that have a higher risk level compared to others in the same asset class. You can’t just recommend any ETF to your clients; you need to make sure they fit their risk tolerance. If you’re recommending an ETF that has a higher risk level compared to others in the same asset class, you need to make sure your client is aware of the risk involved.

Where: Recommended ETFs in your client’s account.

When: Before making the recommendation.

Why: You want to make sure your clients are aware of the risk involved with the ETF you’re recommending.