Hello Reader,
Happy Sunday!
The holiday season is about to start. What are your plans like?
What we should be planning and investing for daily is ETFs.
ETFs have transformed investing, and they’re a popular choice for their flexibility, low fees, and ease of use.
I got a question on Threads yesterday and thought why not do a newsletter about it.
For many investors ETFs, are perfect for a long-term strategy—especially those aiming for financial independence or following the 4% rule in retirement. ETFs make it easier to follow the rule.
But like any investment, ETFs come with risks that are essential to understand for a buy-and-hold approach.
Today, we’ll dive into some of the key factors that impact ETF risk and how you can build a resilient, long-term ETF strategy.
1. Are ETFs in a Bubble?
The growth of ETFs has been rapid, with investors flocking to index funds, and ETFs now representing significant portions of financial markets.
Some analysts worry this creates a potential bubble.
Unlike individual stocks, ETFs may face amplified risks in a downturn because investors often sell off en masse. This can lead to price volatility that may exceed the impact on individual companies, as mass sell-offs could push prices below their intrinsic value.
2. Market Risk and Volatility
ETFs are designed to track various assets or indices, which means they’re exposed to the market’s ups and downs.
For broad-market ETFs (like S&P 500 ETFs), a downturn in the overall market could lead to a steep drop.
Sector-specific ETFs, such as those focused on tech or energy, are particularly susceptible if those sectors hit a slump. Investors should consider the implications of holding sector-focused ETFs, as concentrated exposure can increase volatility.
3. Liquidity Concerns in High-Stress Markets
ETF liquidity usually ensures smooth transactions, but in extreme market conditions, liquidity issues may arise.
For niche ETFs or those focusing on specific sectors or smaller markets, liquidity may dry up quickly. When there’s limited liquidity, ETFs can become difficult to sell without potentially affecting the price, posing challenges if you need to cash out during a market crisis.
This did happen during COVID in March 2020. With ETFs following below their market index.
4. Diversification May Be Limited
Although ETFs often appear diversified, they’re sometimes concentrated in a few large stocks. For example, tech-focused ETFs may look diversified on the surface but are heavily weighted toward top tech giants, like Apple and Microsoft.
This concentration risk can mean that if one major sector or a few large companies struggle, it could impact your entire ETF portfolio.
Balancing ETF holdings with funds covering multiple sectors or different asset classes can help spread out this risk.
5. Tracking Error and Performance Deviation
ETFs aim to mimic the performance of an index, but they don’t always align perfectly, which is known as tracking error. This happens due to expenses, operational inefficiencies, or changes in the underlying index.
Although tracking error is usually minor, it can add up over the long term, impacting total returns. Actively managed ETFs, which attempt to outperform the index, may also struggle to consistently deliver returns after fees.
Strategies to Manage ETF Risks in Long-Term Portfolios
To keep your portfolio resilient while benefiting from ETF investments, consider these steps:
- Diversify Across Sectors and Asset Types: Avoid over-concentration by diversifying into different asset classes, sectors, and geographical regions. Balanced ETFs or those focused on alternative assets, like real estate, can reduce reliance on one sector.
- Rebalance Regularly: Periodically adjust your portfolio to prevent overexposure to any single sector, especially if one segment has grown to an oversized position in your holdings.
- Use Core-and-Satellite Approach: Build a “core” with broad-market ETFs and add smaller “satellite” investments like sector-specific or actively managed ETFs. This approach helps you capture market growth while limiting concentrated exposure.
- Follow the market and my newsletter: Keep up-to-date on trends in the ETF market and emerging risks, especially during periods of market stress. Understanding market cycles and sector risks can help you make proactive adjustments.
Final Thoughts
ETFs remain a valuable tool for building long-term wealth, but awareness of these potential risks is important. By diversifying, rebalancing, and regularly assessing your strategy, you can enjoy the benefits of ETF investing while staying prepared for market changes.
Let’s keep building wealth!
Check out my X post on how to build your first million.
Reply back if you want me to do a post about it next week.
JJs – Personal Finance Insight
@JJsFinclub
Want to build your first million?
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Yours truly,
JJ
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