With historically low interest rates on credit, it can be tempting to borrow money for investments. After all, if you are paying a yearly 2% interest on your loan, the investment doesn’t have to make a particularly huge profit to make you come out on top.
So, is it a good idea to borrow money to invest in Exchange Trader Funds (ETF:s)? That’s a complex question that doesn’t have a simple answer, but we’d like to point out a few risk factors that should ideally be taken into account if you are thinking about using borrowed money to invest in ETF:s.
Never use any type of high interest loan to borrow money to invest in ETF:s. This includes but are not limited to SMS loans, cash advances on your credit card and different types of fast cash loans.
The level of diversification varies widely from one ETF to another. ETF:s are often hailed as highly diversified, but you should scratch the surface before you make any purchase. Sometimes a seemingly diversified ETF isn’t very diversified when push comes to show. The underlying stock index can for instance contain share companies from many different sectors and thereby seem diversified, but only contain share companies that have most or all of their business in one specific country – thus making them highly susceptible to changes within that country.
Just because something is an Exchange Traded Fund, that doesn’t mean that there will actually be someone willing to buy. The liquidity varies significantly between various ETF:s and also over time. For some ETF:s, there will be days between trades.
The tracking error for an ETF is the difference between the reference index or asset and the actual returns of the ETF. If there is a tracking error, it means that the reference has not been completely replicated.
Daily closing price v.s daily NAV
Tracking error is not the same thing as premium/discount. Premium/discount is the difference between the ETF:s market price and the ETF:s Net Asset Value (NAV). The NAV is only updated once a day.
Back in 2008, during a period of market turbulence, the Wall Street Journal reported that some lightly traded ETF:s frequently had deviations of 5% or more. In some cases, the deviation was more than 10%.
Impacting the value of the reference asset
Commodity ETF:s are in essence consumers of their own target commodities, which means that they impact the price in a way that can be misleading if one is not aware of this. For instance, the popular SPDR Gold Shares ETF (GLD) holds 21 million ounces of gold in trust.
A synthetic ETF will always have counterparty risk, since it relies on a counterparty to match the return on the index. Collateral is posted by the swap counterparty, but the investment bank offering the ETF may also post its own collateral and that collateral could be of low quality.
The European guidelines, Undertakings for Collective Investment in Transferable Securities (UCITS) prohibits certain types of dubious set ups in the field. Counterparty risk is therefore generally lower in ETF:s that comply with UCITS.
Several high-profile bodies have argued for more stringent regulation of synthetic ETF. Examples of such bodies are the Financial Stability Board (FSB) and the International Monetary Fund (IMF).