Understanding Investment Risk: The Truth About Self-Inflated ETF Returns

Risk is an inherent part of any investment venture. No matter how ‘safe’ an investment is, there’s always a possibility of losses or lower-than-expected returns.

Risk is measured by the type of investment and the individual investor. Every individual has a unique risk profile that is comprised of many factors such as lifestyle, risk tolerance, financial goals, and age. To make informed decisions, investors need to be aware of the risk of an investment, as well as their own unique risk profile.

In this blog, we’ll explore investment risks in detail, focusing on specific concerns like "hot funds" and self-inflated returns in exchange-traded funds (ETFs). We'll uncover the hidden dangers behind seemingly high-performing funds and equip you with strategies to protect your portfolio from these risks.

Investment Risk Explained

So, you know that risk is unavoidable, but what exactly is investment risk?

Investment risk is the potential for an investor to experience losses or lower returns than initially expected. While every investment carries some risk, the degree of risk varies by asset type, market conditions, and other factors. Here are some key types of investment risks:

Market Risk: The possibility that an investor could lose money due to overall market movements. This could result from changes in interest rates, political instability, or broader economic downturns.
Inflation Risk: The risk that inflation will erode the purchasing power of money, meaning your investment returns might not keep up with rising prices.
Interest Rate Risk: This risk primarily affects bonds and other fixed-income investments, where rising interest rates can lead to falling bond prices.
Risk of not achieving your goals: Your long-term goals, such as retirement, are the foundation of your investment strategy and financial plan. How much risk are you willing to take to achieve your goals?

Understanding these risks is critical to building a portfolio that aligns with your risk tolerance. The most effective way to manage your risk is through diversification, or spreading investments across various asset classes. Diversification helps mitigate risk by ensuring that an underperforming investment doesn't drastically affect your entire portfolio.

The Myth of "Hot Funds"

"Hot funds" refer to mutual funds or ETFs that are performing well and gaining media attention. These funds often attract a wave of new, hungry investors hoping to surf their way into success.

It can be easy to let the hype and fear of missing out (FOMO) tempt you into falling for “hot funds”, but there are significant risks to consider:

Volatility: Funds that have experienced rapid growth may also be prone to sharp declines. These funds are often driven by short-term market trends that can reverse unexpectedly.
Inflated Expectations: Investors may assume that past performance will continue, leading them to overestimate future returns.
Difficulty Sustaining High Returns: Even well-performing funds may struggle to maintain high returns over time due to changes in market conditions or the natural business cycle.

Popular funds aren’t always inherently bad, but sometimes FOMO can give investors tunnel vision. Never ignore the risks of an investment just because it’s performing well in the market today. Always do your own research and due diligence before jumping on an investment opportunity.

Self-Inflated Returns in Exchange-Traded Funds

Exchange-traded funds (ETFs) are a broad collection of stocks, bonds, and other securities that can be bought and sold on the stock exchange. They are often seen as a flexible and cost-effective way to diversify your portfolio, offering liquidity, low fees, and instant access to a broad range of assets. ETFs are also passively managed and tend to incur few capital gains, making them tax-efficient investments.

However, ETFs are not immune to misleading or poor performance metrics. One of the most common pitfalls is the appearance of self-inflated returns—misleadingly high investment performance figures—which can result from several biases:

Survivorship Bias: This occurs when investors focus on the success of ETFs that have outperformed the market, while ignoring those that have failed or underperformed. It creates an illusion that an investment is performing better than it actually is.
Backfill Bias: Some ETFs might retroactively add (or backfill) successful historical data to improve their performance record, creating an illusion of consistent success. This misleads investors into thinking that a fund is performing better than it actually is.
Market Timing: ETF managers may cherry-pick favorable time periods for reporting returns, masking periods of underperformance. This tactic creates an impression of sustained growth, even if it’s not the case across all time frames.

Self-inflated returns can mislead investors into thinking a fund or investment is less risky or more consistently profitable than it truly is. For example, an ETF that tracks a booming tech sector might report stellar returns during a market upturn, but it may not disclose how it fared during a downturn.

These distortions can mislead investors into believing they are entering a "safe" and "high-return" investment when in reality, the risks have been intentionally concealed. Pretty sneaky stuff!

3 Strategies for Mitigating Investment Risk

To avoid being misled by “hot funds” and self-inflated returns, investors should adopt a proactive approach to risk management. With any investment opportunity, you should always do 3 things to help mitigate investment risk:

Complete thorough research: Before investing in any fund, you must do your due diligence. Analyze a fund's strategy, review historical performance, and ask as many questions as you need to ensure that you are 100% confident with the investment before you write a check.
Diversify across asset classes: A well-balanced portfolio includes a mix of assets, including stocks, bonds, real estate, and commodities. Diversification spreads risk, helping to minimize the impact of a downturn in any single asset class.
Adopt a long-term perspective: Market fluctuations are inevitable, and even though they can be stressful, it’s important to stay disciplined during times of volatility. Investors who stick to their long-term investment goals are more likely to achieve sustained success.

Your Investment Journey Begins Here

Investment risk is unavoidable, but by understanding the complexity of risk and your own risk profile, you can make more informed decisions to protect your wealth. While "hot funds" and self-inflated ETF returns can be tempting, remember that they often come with hidden dangers. As an investor, it’s essential to look beyond surface-level performance and adopt strategies that manage risk effectively.

If you're looking for personalized advice on managing investment risks or building a well-diversified portfolio, the team at Michael Brady & Co. is here to help. Contact us today to discuss tailored investment strategies that align with your goals and risk tolerance!