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Principal Investment Risks

Standard deviation of returns is referred to as a measure of an individual security’s, or an investment portfolio (IP) total risk which can be broken down into:




-exchange rate;

-country (political) risks. 

Taking into account and analyzing the above mentioned risks, a prudent investor will require a risk premium as a function of all of them. It is necessary to mention that all the risks as described below are inter-depended, commingling and in real life overlap each other. They have been singled out on the purpose of this research to show the particular role they might play in the investment strategy.

Any individual asset possesses, so-called, unsystematic risk, which is unrelated to the market’s portfolio variance, arises from the asset’s unique features and risks, can be and should be eliminated by portfolio diversification. Under this assumption, “the risk premium of an individual earning asset is a function of the asset’s systematic risk with the aggregate market portfolio of risky assets”, Brown and Reilly (2009). 

Systematic (un-diversifiable, or market) Risk is impossible to manage by portfolio diversification. It is a portion of an individual asset’s total variance caused by overall market portfolio variability, and statistically measured as R-squared. The second portion is represented by the above mentioned unsystematic risk.

The net asset value (“NAV”) and investment return might be negatively affected as a result of adverse changes in market prices of the securities the investment portfolio consist of, consequently, a portfolio can underperform its benchmark. Neither of the ETFs as those of developed so those of emerging markets are insured or guaranteed by the governments of the countries.

The indisputable advantage of the investment strategy in question is that the diversification is extremely wide, because the role of an “individual” asset in this case plays an ETF, which is simultaneously as liquid as an individual stock and is already diversified, which it its turn lowers un-systematic risk. Another advantage is that the portfolio manager combining ETFs from different countries can measure and take as much systematic risk as he/she wants at a given time.

Aor example, reducing the weights of the developed markets’ ETFs in the portfolio, and adding the weights of those of emerging markets denominated in weaker currencies (Asian, South American currencies) the  manager can in no time enhance risk he/she (or his/her client) is prepared to take.

Even changing the weights of currencies in developed markets’ portfolio, such as reducing the weight of European currencies and rising the weights of the US denominated ETFs the manager can modify the risk of the portfolio to his/her heart content.

It becomes even more important when markets’ volatility is very high as it currently is, and when there are more uncertainties, like Eurozone crisis, regional wars, conflicts, etc.

Financial Risk. The uncertainty which arises from the way an investor finances its investments. Since the strategy in question doesn’t involve borrowing and doesn’t use any leverages no initial financial risk is present. Nevertheless, financial risk can arise as a result of the changing in the Net Asset Value (NAV) when there are some financial instruments as forwards (or futures) contracts involved in order to get an exposure in a certain currency.

Liquidity Risk. The uncertainty arises from the probable ability (or inability) of an investor to convert a stock he/she had acquired back into cash.  The more difficult it is to make a conversion, the higher the liquidity risk is. There are two main uncertainties as far as the liquidity is concerned:

-how certain is the price to be received, and

-how long will it take to sell the investment at the expected (predicted) price?

The less the liquidity the higher the uncertainty is to not sell the investments at the expected price. Therefore, the Portfolio  may lose money or be prevented from realizing capital gains if it cannot sell a security at a particular time and price or may be forced to hold investments longer than it would like and may forego other investment opportunities. In the study covering the period from April 2007 to March 2008, just prior to the beginning of the world’s economic and financial crisis,  Schwarts (2009) found that on average 77% of sovereign spread is explained by liquidity.

As far as our ETFs are concerned, the liquidity of those assets trading on the US, European and most of the Asian exchanged is very high and therefore this risk is very low for the ETFs traded on the above mentioned exchanges. But when it comes to the Russian ETFs, the liquidity is one of the most significant risks an investor has to take into account and, therefore, to require a higher risk premium.

Counterparty Risk. The uncertainty of the ability of the counterparty to any financial instrument entered into by the ETF (or investment portfolio of ETFs) to meet its obligations in full. Counterparty may fail to fulfill its obligations and even become bankrupt due to financial difficulties, newly launched state regulations, any other problems.

Trading in an ETF may be halted if the trading in one or more of the ETF’s underlying securities is halted. This risk is definitely higher in emerging markets where financial markets regulations, practice and the markets themselves are young, and law enforcement can be significantly influenced by corruption.

Interest rate risk. The uncertainty of returns arising from rise or fall in interest rates within economies in different countries. Rising interest rates will negatively influence performance of the bonds used in ETF portfolio composition as “the bond will appear less attractive and the market price of the bond will fall”, Ryan, B. (2007).

Equity ETFs will also be adversely influenced by the rise in interest rates as it will lead to more expensive borrowing, rise in unemployment and sometimes deterioration of the economy overall.  At the same time, lower interest rates will boost performance of equities and cause growth in bonds’ prices. Changes in interest rates might also lead to the changes in foreign exchange rates vie Interest Rates Parity mechanism: the higher the interest rate the higher the course of the currency (assuming there are no state regulations creating market imperfections).    

Inflation risk. The uncertainty of returns caused by unexpected changes in the inflation rates. Rise in the rate of inflation can require and cause higher interest rates, which can in its turn, influence ETFs’ performance as discussed above.

Changes in the rates of inflation might also influence foreign exchange rates through the Purchasing Power Parity mechanism: the higher the inflation rates the lower the course of the currency (assuming there are no state regulations creating market imperfections). Historically low rates of inflation positively influenced the performance of equities, whereas higher inflation rates’ influence was rather of adverse nature. 

Exchange Rate Risk. The uncertainty of returns arising from investments denominated in a currency different from the investor’s domestic currency. The higher the volatility of the currency the higher the exchange risk is. It is also worth mentioning that most if the assets the Investment Portfolio will be investing in vie ETFs will be shares of biggest multinational corporations and therefore the currency exposure will still be indirectly present but not manageable by the portfolio manager.

Using miscorrelations between different currencies and first of all between the US Dollar and the basket of other currencies it is possible to get an investment portfolio with lower volatility and consequently lower risk. Regarding the Investment Portfolio performance, adverse changes in exchange rates may negatively affect the value of the investments in its reference currency, including forward contracts, futures, cross currency forwards, other derivatives involved in the Investment Portfolio composition.

Many ETF providers use forward contracts to manage currencies exposure and consequently to produce currencies’ hedged ETFs. Whereas there are one, two, three, six-or twelve-month-long forward contracts, the industry standard is utilizing a one-month forward which allows fund manages to lock in current exchange rates and therefore manage the currency risk their bear. 

Derivatives and Currency Management Risk.  The uncertainty of returns arising from management strategies involving different classes of derivatives: forwards and futures contracts, swaps, etc. The risk arises, as it has been described earlier, because of the changes in the market value of the underlying assets, which leads to the additional and undesirable exposure in the derivatives already held in the portfolio. Such changes to the exposure could result in losses to the Investment Portfolio if currencies do not perform as the managers expects.

Default risk. The uncertainty of returns arising from the failure of the borrower to repay either interest or the entire capital. Such a risk is only run by ETFs investing in bonds. Rating agencies publish credit ratings of governments and corporate bonds which allow investors and fund managers to measure the risk and to take exactly the desirable risk level. According to Ryan, B. (2007), the default risk of corporate bonds can be mitigated asthe bond holders will normally have the right, in the case of a corporation, to put the company into the hands of “receivers”. Receivership is the first stage of corporate bankruptcy”.

Reinvestment rate risk is in the case of ETF investment realized in the fact that dividends can only be reinvested ones a month. In case of bond ETFs there might be an uncertainty in the reinvestment rate assumed in calculating the factual yield the receipts from bonds are reinvested as the yield may vary in time.

Country (political) Risk. The uncertainty of some major changes in current political and, or an economic environment of a country, which may adversely influence returns of the ETFs (investment portfolio). It is commonly thought that developed markets associated with developed democracies are significantly more stable politically and economically compared to their emerging markets peers. But taking into account a huge amount of sovereign debt piled by such countries as the US, UK, Italy, Spain, Portugal, and obviously Greece, which has already led to the changes of governments in Italy, Spain, Greece, some other countries, this currently might not be the case.

Information Risk.  The uncertainty of returns arising from the lack of the appropriate and timely information, or deliberately issued disinformation. It leads market prices to not reflect all the macro-economic or the issuer’s condition because there is no sufficient publicly available factual information. The above mentioned makes inside trading not only possible but rather frequent, which significantly undermines the entire idea of the efficient markets and fair trade. The risk is specific for developing and emerging markets, the Russian one in particular, and can significantly adversely influence the performance of the assets denominated in both local and foreign currencies.

Geographic Concentration Risk. The uncertainty arises from economic, political or regulatory events affecting those countries or regions in which an ETF has significant exposure in particular if the size of the economy is relatively small, for example, earthquake in Australia in 2010.

Taxation Risk. The uncertainty arises from unexpected changes in taxation in the countries ETF has exposure in. Such changes can influence the performance both positively-lower taxation rates, and, which is of rather higher probability under current economic situation, higher taxation rates-negative impact on the ETF return.  

Trading Practices Risk. Government supervision and regulation of foreign stock exchanges, currency markets, trading systems and brokers may be unfavorable for the ETF performance.