Delve into the key risks ETF investors face, including market risk, tracking error, liquidity challenges, concentration exposure, counterparty risk, and currency fluctuation. Learn practical strategies to mitigate these risks within the Canadian regulatory framework.
Exchange-Traded Funds (ETFs) have grown significantly in popularity among Canadian investors. They offer diversification, convenience, and often lower fees than many mutual funds. However, despite these advantages, ETFs still carry inherent risks. In this section, we explore the major categories of risks associated with ETF investments, illustrate them with real-world Canadian examples, and discuss regulatory considerations specific to the Canadian market. By understanding these risks, investors can make more informed decisions and align ETF investments with their broader financial goals.
As with any security, ETFs are subject to market risk. When overall market sentiment deteriorates—due to macroeconomic factors, geopolitical tensions, or unexpected events—ETF values can decline.
• If a Canadian pension fund invests in an ETF tracking the S&P/TSX Composite and the Canadian market experiences a significant correction, the ETF’s value will also drop proportionally.
• Diversify across different asset classes (equities, fixed-income, commodities, etc.).
• Reassess your long-term investment strategy to ensure you have a suitable asset allocation for your risk tolerance.
• Utilize stop-loss orders or hedging strategies, where suitable, although be mindful of transaction costs.
“Tracking error” refers to the difference between the ETF’s actual returns and the benchmark index it intends to replicate. While most ETFs strive to minimize this gap, several factors can cause discrepancies:
• Management Fees: Even if the ETF is passively managed, fees slightly reduce returns.
• Sampling Methods: Some ETFs hold a representative sample of securities rather than the entire index, which can lead to performance deviations.
• Illiquidity of Underlying Securities: Thinly traded or hard-to-obtain components of an index can increase transaction costs, driving the ETF away from perfect index replication.
Imagine an ETF that aims to track a corporate bond index. If certain bonds within the index are thinly traded or have wide bid-ask spreads, the ETF manager may not be able to replicate the exact holdings. This partial replication approach can introduce performance deviations.
• Choose ETFs with relatively low management expense ratios (MERs).
• Evaluate the manager’s replication strategy. Full replication often provides tighter tracking than sampling.
• Review historical tracking error data published by the ETF provider for consistency.
Liquidity risk arises when an ETF—or the securities that underlie it—is difficult to buy or sell without significantly influencing its price. While widely traded ETFs (like those that track major benchmarks) have robust liquidity, some niche ETFs with low daily trading volumes can present liquidity challenges.
• Wider Bid-Ask Spreads: When the trading volume is thin, investors may face higher transaction costs.
• Price Volatility: With fewer buyers and sellers, even modest trades can cause noticeable price fluctuations.
A specialized ETF focusing on a narrow technology subsector may garner limited interest among investors. If you want to liquidate your position quickly during a downturn, you might accept a significantly lower bid price, thereby crystallizing losses.
• Check average daily trading volume before investing.
• Use limit orders instead of market orders to control the execution price.
• Maintain a diversified portfolio, reducing dependence on highly specialized ETFs.
Concentration risk occurs when an ETF is heavily focused on a specific sector, theme, or geographic region. While this focus can deliver impressive upside if the sector performs well, it also heightens volatility and the potential for losses.
A Canadian Real Estate ETF might hold positions in a dozen major real estate investment trusts (REITs). Should the real estate market decline—perhaps due to rising interest rates or an economic slowdown—unitholders might face disproportionately large losses compared to more diversified ETFs.
• Balance sector or thematic ETFs with broader market ETFs.
• Monitor economic indicators relevant to the sector, such as interest rates for real estate or commodity prices for natural resource ETFs.
• Periodically rebalance your portfolio to maintain target exposure levels.
Some ETFs—particularly inverse or leveraged ETFs—rely on derivatives such as swaps or futures contracts. Under these agreements, the ETF is exposed to the solvency of the counterparty. If the counterparty defaults, the ETF may not receive the promised payment, resulting in losses.
flowchart LR
A(Investor) -->|Buys Shares| B(Inverse/Leveraged ETF Manager)
B -->|Uses Swaps, Futures| C(Derivative Counterparty)
C -->|Exposure to Market| D(Market Prices)
Consider an inverse ETF designed to move opposite to Canadian energy stocks. If it uses swaps with a large bank (e.g., RBC or TD) as the counterparty, a financial crisis could, in extreme cases, jeopardize the bank’s ability to meet its obligations. While Canadian banks are known for financial stability, no institution is entirely free of credit risk.
• Review the ETF’s prospectus to identify derivative exposure.
• Choose ETFs from issuers with robust risk management policies.
• Keep track of the creditworthiness and regulatory environment of the counterparties.
ETFs that hold foreign securities, such as U.S. equities or global bonds, expose investors to fluctuations in foreign exchange rates. If the Canadian dollar appreciates relative to the currency of the underlying securities, the value of your ETF holdings may decline, unless the fund is hedged.
• Suppose you invest in a U.S. Equity ETF listed on the Toronto Stock Exchange (TSX). If the Canadian dollar strengthens against the U.S. dollar, your returns from the underlying U.S. stocks may shrink once converted back to CAD.
• Currency-Hedged ETFs: These use derivatives (like currency forwards) to mitigate exchange risk.
• Unhedged ETFs: May yield higher returns if the foreign currency appreciates but amplify losses if the foreign currency weakens.
The table below summarizes the key ETF risks:
| Risk | Description | Potential Impact |
|---|---|---|
| Market Risk | Overall market fluctuations | Broad losses in value |
| Tracking Error | ETF return diverges from benchmark | Underperformance vs. index |
| Liquidity Risk | Difficulty buying or selling the ETF | Wider spreads, higher transaction costs |
| Concentration Risk | Heavy investment in a single sector or theme | Increased volatility and potential for loss |
| Counterparty Risk | Dependency on derivative counterparties | Losses if counterparty defaults |
| Currency Risk | Exposure to changes in currency exchange rates | Lower returns when CAD strengthens |
Canadian investors benefit from robust oversight by organizations such as the Canadian Securities Administrators (CSA) and the Canadian Investment Regulatory Organization (CIRO). Key resources and guidelines include:
By staying informed of regulatory updates, thoroughly reviewing ETF prospectuses, and understanding how each of these risks can impact returns, Canadian investors can better position themselves to manage the long-term implications of ETF investments.
CSC® Vol.1 Mastery: Hardest Mock Exams & Solutions
• Dive into 6 full-length mock exams—1,500 questions in total—expertly matching the scope of CSC Exam 1.
• Experience scenario-driven case questions and in-depth solutions, surpassing standard references.
• Build confidence with step-by-step explanations designed to sharpen exam-day strategies.
CSC® Vol.2 Mastery: Hardest Mock Exams & Solutions
• Tackle 1,500 advanced questions spread across 6 rigorous mock exams (250 questions each).
• Gain real-world insight with practical tips and detailed rationales that clarify tricky concepts.
• Stay aligned with CIRO guidelines and CSI’s exam structure—this is a resource intentionally more challenging than the real exam to bolster your preparedness.
Note: While these courses are specifically crafted to align with the CSC® exams outlines, they are independently developed and not endorsed by CSI or CIRO.