How safe are ETFs? You should be aware of these risks!
ETFs are becoming increasingly popular and are considered inexpensive and easy to understand. They have now become an alternative to traditional asset classes such as fixed-term deposit accounts or building society savings accounts, as they can generate higher returns. You may be wondering, ‘How safe are ETFs?’ In this article, you will learn about the security risks associated with ETFs and how you can counteract these disadvantages!
In brief:
- External factors influence price fluctuations on the markets
- Thematic investments offer the opportunity for high returns, but they also involve risks.
- Before investing, you should familiarise yourself with topics such as exchange rate risk and counterparty risk.
- If you follow our tips, you can counteract the risks of ETFs, increase security and have the chance of an attractive return on a comparatively safe investment.
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What are ETFs?
Before we look at the reasons for investing and the potential risks, it makes sense to take a closer look at ETFs and how they work. As a general rule, you should only invest in asset classes if you understand how they work and are aware of the potential risks and how to deal with them.
Definition and functioning of ETFs
The term describes an exchange-traded fund. Investors can invest in a fund together with other investors. Depending on the strategy, this money is used to invest in a specific investment product. Examples include real estate funds, equity funds, bond funds and mixed funds. Funds can also be divided into:
- Active management: A fund manager actively attempts to change the composition of the fund in order to achieve excess returns. He selects individual securities and determines the timing of purchases and sales. Active management is the reason for higher costs.
- Passive management: The composition of passive funds is already fixed; no fund manager is required. The objective is to generate the average return of the respective market; no attempt is made to achieve excess returns. ETFs are a passive asset class.
When an investor invests in an ETF, for example one linked to the DAX, they are investing in all of the companies contained therein. By purchasing a security, an investor can invest in the 40 largest German companies. The aim of investing in this type of investment is to achieve exactly the same return as the DAX.
Attention!
This fact offers the advantage of diversification. By spreading your capital, you have the opportunity to reduce risks. If, on the other hand, you invest only in a few individual stocks or sectors, you bear an increased security risk.
A top ETF, such as the MSCI World, invests in over 1,500 companies worldwide, spread across various sectors. This is considered a popular ETF for beginners, allowing you to build a so-called global portfolio in order to benefit from the stock market in as diversified a manner as possible.
When a company makes a profit, it can distribute this to its shareholders in the form of dividends. If you decide to invest in a secure ETF, you have two options:
Distribution options for ETFs
- Accumulating: The dividends you have earned on your investment are reinvested directly. This allows you to benefit from compound interest, as further returns can be generated. This option is particularly suitable for long-term investors.
- Distributing: If you choose this option, the dividends will be paid out to you by the fund provider and transferred directly to your account. The value of your fund assets will decrease as a result, but you can do whatever you want with the dividends.
You may be wondering whether to buy ETFs or set up a savings plan. Both are possible with ETFs. If you already have a large amount of assets that you want to invest, a one-off purchase is the obvious choice. This way, your entire assets can work for you and generate returns. For larger sums, the timing of the purchase plays a role.
Attention!
If you are still a beginner and would like to start with small amounts, setting up a savings plan is a good option. This allows you to invest a certain amount automatically each month and work on building up your long-term assets.
Why invest in ETFs?
ETFs are becoming increasingly popular among beginners and advanced investors alike and are particularly suitable for investors with long-term goals:
- Securing your family’s financial future
- Investing money for children
- Compensate for inflation
- Build passive income
- Providing for old age
In connection with the reasons just mentioned, ETFs offer one thing above all else: the chance of attractive returns. Traditional types of investment such as building society savings accounts or savings accounts are no longer suitable for generating returns. Often, they can no longer even be used to offset inflation.
Good to know:
Inflation describes a general rise in prices. This causes your savings to lose value. High inflation rates mean that you can buy fewer and fewer services or products for the same amount of money.
The returns on ETFs depend on their exact composition and can vary considerably. Investors often use ETFs to invest in stocks. In the long term, stocks offer the best chances of generating high returns. Annual returns of 7 to 9 per cent are realistic for a long investment horizon.
Advantages of ETFs
A particular advantage of this asset class is its low costs. Unlike managed funds, the passive nature of the investment prevents high fees. Costs generally range from 0.05 per cent to 0.8 per cent of your investment amount. For investments with active fund management, you can expect fees of up to 5 per cent of the investment amount.
The diversification opportunities mentioned above are helpful in increasing security. An index, which often contains hundreds or thousands of securities, is broadly diversified and one of the most important advantages of this asset class. Compared to buying individual shares, the risks associated with ETFs are significantly lower.
Another positive aspect is the transparency offered. You can find the exact composition of the indices on the websites of the respective providers: the percentage invested in each country, which companies are included and in what proportions, the amount of costs and all other information. The composition is updated regularly to ensure transparency for investors.
ETFs offer a high degree of flexibility. If, for example, you have set up a savings plan, you can constantly change, increase, pause or terminate it. You are offered many options for adapting the asset class to your financial situation. Nevertheless, the same applies here: it is advisable to develop a strategy and stick to it.
Attention!
This type of investment is generally liquid. You can buy or sell securities on the stock market every day and convert them back into cash. The only restriction is the opening hours. However, you should bear in mind that this is a long-term investment.
What are the risks associated with ETFs?
You may be wondering what the disadvantages of ETF funds are. ETFs are not suitable for every investor and can vary considerably in their composition. Nevertheless, there are some common risks and potential disadvantages, which are explained below.
General market risk due to price fluctuations
As a general rule, you should expect fluctuations in products traded on the stock market, and ETFs are no exception. External influences, such as political news, affect the stock market and have an impact on prices.
Specific influences include, for example, interest rate decisions by central banks or new legislation affecting the economy. Unforeseen events can also occur and cause prices to temporarily swing sharply in one direction or the other. Major cycles of price increases or decreases are referred to as bull markets or bear markets.
Throughout history, stock market crashes have occurred repeatedly, causing prices to fall sharply for a certain period of time. One example that is not too far in the past is the coronavirus pandemic and its impact on the economy.
In such difficult economic times, it is important that you do not sell your shares in a panic, but remain true to your strategy. A long-term investment horizon of at least 10 to 15 years is particularly suitable for compensating for fluctuations.
Attention!
Price fluctuations on the stock market are normal and commonplace. In times like these, remember that after a low point, prices will rise again sooner or later.
Thematic ETFs – high returns or high risk?
Some ETFs aim to be as broadly diversified as possible and to achieve the average market return. One example is the MSCI World, which is particularly beginner-friendly and covers numerous industrialised countries.
Other ETFs aim to achieve particularly high returns. One example of a high-return ETF is a hydrogen ETF. However, a higher chance of return is accompanied by a higher security risk. Investments such as these are referred to as thematic ETFs. They are characterised by the following features:
- Thematic investments often focus on major trends such as sustainability or impending social change.
- They often invest in only one country or a specific industry.
- A hydrogen ETF, for example, invests in suppliers of hydrogen, storage, gas production or industrial applications. Assets outside of hydrogen are not included.
- It contains fewer companies than the global versions.
Because thematic ETFs invest in potential future trends, they often have the opportunity to generate excess returns. However, they also involve significant risks: investing in only a few countries and one industry means that there is insufficient diversification. Thematic investments are not considered safe investments.
If the sector performs worse than expected, losses are more likely and cannot be offset by other companies performing better. As a beginner, you should focus less on thematic investments. This type of investment is more suitable for experienced investors who already have a diversified portfolio and want to increase their returns.
Exchange rate risk
ETFs are offered in different currencies such as US dollars or euros. Basically, there is only one price, which can be expressed in different currencies. As soon as you invest in securities that have a different currency than your own, an exchange rate risk arises.
Exchange rate risks can be problematic for investors who buy and sell quickly and trade investments in different currencies. If, on the other hand, you are focusing on a long investment horizon, historical data has shown that exchange rate fluctuations even out and you do not need to worry about reduced returns.
Counterparty risk
A distinction is made between physical and synthetic replicating ETFs. The physical variant purchases exactly the stocks contained in the investment. The synthetic variant, also known as a swap, can contain securities from different stock exchanges.
If you choose a swap ETF, your provider enters into a contract with a swap partner. The partner guarantees the profits that are achieved with the corresponding index. The provider and the investor are therefore dependent on the partner fulfilling their obligations.
This is also known as counterparty risk. By law, 90 per cent of your investment amount is secured in a swap trade, but the remaining 10 per cent is not.
Liquidity bottlenecks
In the context of financial investments, liquidity refers to how quickly the invested money can be converted into bank deposits or how quickly you can access your money when needed. Together with profitability and security, liquidity forms the magic triangle of financial investment.
In principle, you can buy or sell your ETFs on the stock exchange every day during normal opening hours. However, there are two possible reasons why liquidity bottlenecks may occur.
On the one hand, it is possible that there will be a large number of panic sales. A sudden, sharp fall in prices may occur if a large number of investors sell a lot of securities.
Even with popular asset classes, it can happen that no buyer can be found temporarily. In such cases, the trading system is often suspended for a short period.
How to avoid liquidity bottlenecks caused by panic selling:
- Try to keep your emotions under control and wait and see.
- Do not allow other investors to unsettle you.
- Stick to your pre-planned investment horizon
- Develop a strategy before investing. In difficult times of crisis, you will know that you are well prepared and will be less inclined to deviate from your financial plan.
- Inform yourself sufficiently: once you have acquired a lot of knowledge, you will notice that you are less afraid of price slumps, as you are aware that fluctuations are normal and to be expected.
Another possible cause of liquidity bottlenecks is niche stocks. For example, when it comes to smaller thematic ETFs that are less well known and less widespread, it may not be possible to find a buyer immediately.
This problem can be easily circumvented by sticking to frequently traded stocks or ETFs. For beginners, the MSCI World, for example, is a good option for building a globally diversified world portfolio.
Attention!
Every investor should have liquid investments that they can fall back on in an emergency to have money available. One example is instant access savings accounts, as you can transfer money from these to your everyday account at short notice. You should keep an emergency fund of 3 to 4 months’ salary in a liquid investment.
Conclusion: ETFs as a secure form of investment with sufficient diversification
Exchange-traded index funds, such as ETFs, are an attractive asset class for offsetting inflation, providing for your family or saving for retirement. They offer flexibility, low costs and opportunities for returns. Their ease of understanding makes them suitable for both beginners and advanced investors.
Despite all the advantages, there are also potential disadvantages and risks associated with ETFs. All asset classes traded on the stock market are subject to price fluctuations. Other risks include thematic ETFs and exchange rate risk. Depending on the type of investment, there may also be counterparty risk.
If you inform yourself sufficiently, there are good ways to counteract the risks and increase security for all problems. Sufficient diversification can help you reduce the security risk.
A long-term investment horizon is particularly effective in offsetting price fluctuations or exchange rate risks. If you follow these tips, you have the chance of attractive returns in the future! You can find out more about ‘what to invest in’ here.
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FAQ – Frequently asked questions: How secure are ETFs?
