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The Hidden Dangers of ETFs That Can Lead To Lost Savings

Exchange traded funds (ETFs) have in recent years become one of the most popular investment vehicles for small to mid-sized investors. ETFs are attractive for many average investors because of the relatively low investment required. Investors also often choose ETFs because they are traded on the stock exchange and can be purchased through a stock broker. But, many investors in ETFs are exposing themselves to hidden risks that they may not be aware of. These risks expose investor’s life savings to potentially huge losses.

What is an ETF?

An ETF is a type of mutual fund that is traded on the stock exchange. An ETF can hold almost any financial asset including commodities, bonds, derivatives or stocks. Originally most ETFs were designed to track a particular index such as the S&P 500. But as ETFs have become more popular, they have also become more “exotic.” ETFs are now used to hold volatile financial assets such as oil futures and emerging market stocks. As a consequence many ETFs pose risks that investors are unaware of.

Risk #1 – ETFs Are Frequently Difficult To Understand

The major problem with ETFs is that investors, and even that financial advisers that recommended them, frequently do not understand exactly what they are investing in. Prospectus for ETFs are often complex and difficult for even financial professionals to understand. Investors may find themselves exposed to financial derivatives, equity swaps and entire asset classes that they didn’t realize that they were investing in.

Risk #2 – Highly Leveraged ETFs

Many investors are unaware that they are exposing themselves to high levels of leverage. Leverage is when money is borrowed to purchase more of a particular financial asset. Using leverage can increase potential returns. But it also increases the amount of risk. While leverage can be useful when used wisely, many ETF investors are unaware of the amount of risk that they are exposing their life savings too.

Risk #3 – The Spreads Can Be Large

The spread is the difference between the bid and the ask price for a particular financial asset. In the case of smaller ETF’s and those which hold stocks which don’t trade frequently, the spread can be quite large. This is a hidden cost that is born by the investor in the ETF. This is particularly problem with ETFs investing in emerging markets where stocks often trade infrequently and with large spreads.

Risk #4 – The Danger of Front Running

Another danger that most investors are unaware of is the possibility of front running. ETFs are required to disclose what stocks they hold daily. This transparency can place the ETF at a disadvantage to hedge funds and other savvy financial players. When hedge funds see that an ETF is purchasing a particular stock they can purchase the shares ahead of the ETF and thus drive up the price. This can reduce the potential profits that an ETF can make.

Conclusion

Exchange traded funds have become viewed by many investors as being “safer” because they are traded on the stock exchange and frequently track indices. This is a dangerous view which neglects the many hidden risks that are associated with ETF’s. Investors are increasingly becoming exposed to financial derivatives, such as futures contracts, without them even being aware of it. This can potentially result in huge losses to the investor’s life savings. Many investors need to rethink whether ETF’s really are the right investment vehicle for them.

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