Exchange Traded Funds: Systemic and Nonsystemic Risk

In the case of indexed ETFs and mutual funds, safety is provided (to a limited degree only!) by diversification in that they represent ownership in many different securities. Owning many stocks, rather than a few, provides some safety by eliminating something that investment professionals, when they’re trying to impress, call nonsystemic risk.

Nonsystemic risk is involved when you invest in any individual security. It’s the risk that the CEO of the company will be strangled by his pet python, that the national headquarters will be destroyed by a falling asteroid, or that the company’s stock will take a sudden nosedive simply because of some Internet rumor started by an 11th-grader in the suburbs of Des Moines.

Those kinds of risks (and more serious ones) can be effectively eliminated by investing not in individual securities but in ETFs or mutual funds.

Nonsystemic risk contrasts with systemic risk, which, unfortunately, ETFs and mutual funds cannot eliminate. Systemic risks, as a group, simply can’t be avoided, not even by keeping your portfolio in cash. Examples of systemic risk include the following:

  • Market risk. The market goes up, the market goes down, and whatever stocks or stock ETFs you own will generally (though not always) move in the same direction.

  • Interest rate risk. If interest rates go up, the value of your bonds or bond ETFs (especially long-term bond ETFs such as TLT, the iShares 20-year Treasury ETF) will fall.

  • Inflation risk. When inflation picks up, any fixed-income investments that you own (such as any of the conventional bond ETFs) will suffer. And any cash you hold will start to dwindle in value, buying less and less than it used to.

  • Political risk. If you invest your money in the United States, England, France, or Japan, there’s little chance that revolutionaries will overthrow the government anytime soon. When you invest in the stock or bond ETFs of certain other countries (or when you hold currencies from those countries), you’d better keep a sharp eye on the nightly news.

  • Grand scale risks. The government of Japan wasn’t overthrown, but that didn’t stop an earthquake and ensuing tsunami and nuclear disaster from sending the Tokyo stock market reeling in early 2011.

Although ETFs cannot eliminate systemic risks, don’t despair. For while nonsystemic risks are a bad thing, systemic risks are a decidedly mixed bag. Nonsystemic risks, you see, offer no compensation. A company is not bound to pay higher dividends, nor is its stock price bound to rise simply because the CEO has taken up mountain climbing or hang gliding.

Systemic risks, on the other hand, do offer compensation.

  • Invest in small stocks (which are more volatile and therefore incorporate more market risk), and you can expect (over the very long term) higher returns.

  • Invest in a country with a history of political instability, and (especially if that instability doesn’t occur) you’ll probably be rewarded with high returns in compensation for taking added risk.

  • Invest in long-term bonds (or long-term bond ETFs) rather than short-term bonds (or ETFs), and you are taking on more interest-rate risk.

That’s why the yield on long-term bonds is almost always greater.

In other words,

Higher systemic risk = higher historical returns
Higher nonsystemic risk = zilch

That’s the way markets tend to work. Segments of the market with higher risks must offer higher returns or else they wouldn’t be able to attract capital. If the potential returns on emerging-market stocks (or ETFs) were no higher than the potential returns on short-term bond ETFs or FDIC-insured savings accounts, would anyone but a complete nutcase invest in emerging-market stocks?

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