Many equity indices have reached record highs in recent times, which could mean a correction is imminent. This may be a risk for exchange-traded funds (ETFs) that track one of the major bourses.

Geopolitical tensions, bearish bond markets and the potential for some ETFs to suffer poor liquidity in a downturn are other risk factors investors should be aware as we enter the New Year.

Local market trends

The ASX 200 has traded above 7000 points since mid-January, driven by low interest rates, bullish investor sentiment around Brexit’s resolution and a détente in the US/China trade war.

This poses the risk of a correction, and ETFs that track the index such as the Vanguard Australian Shares ETF could suffer in this situation.

“The market has had a good run but it can’t stay high forever and there may be a small correction between now and February or March,” Dimitri Argyros, a financial adviser with Silver & Young Private Wealth, says.

“Few investors anticipated the 20% return the ASX 200 delivered last year. But overall, I still think there is the potential for moderate growth this year. This will depend on how the US market performs in light of the US and Iran issue, the US’s relationship with China and Brexit,” he adds.

The Aussie ETF providers that made it rich in 2019

Certified financial planner James Gerrard is also among the bulls when it comes to the way markets are likely to perform this year and the performance of ETFs that track them.

“Even though valuations looks stretched and the market toppy, the general consensus is markets are likely to have another good year. Promises and optimism around the US election, the UK’s exit of the European Union on good terms, the Olympics in Japan and the US/China phase one trade deal are all positives for markets,” Gerrard says.

“But markets are not cheap and it just takes one piece of bad news to turn sentiment on its head. The problem is it is difficult to predict what will be the bad news that turns the market and when it will happen,” he says.

Bad news for bonds

Turning to fixed income ETFs, there is a view the performance of long-dated bond ETFs may be lacklustre this year.

“The bond curve steepens when long-term interest rates rise. At the same time, longer-dated bonds’ capital value falls, with potential capital losses extending into double digits,” Gerrard says.

Six ETF themes for Aussies in 2020

ETFs such as the Vanguard Australian Government Bond ETF and Vanguard’s International Fixed Interest Index (Hedged) ETF could suffer in this environment.

“They may underperform as central banks near the end of easing measures. With the global economy in ok shape, there may be upward pressure on long-term bond yields to come this year,” he adds.

Geopolitical tensions to dominate market sentiment

Kyle Frost, an independent financial adviser with Millennial Independent Advice, cautions investors against acting on investment decisions based on political events.

“Leading up to the 2016 US election a lot of clients rightly predicted Trump would win and as a result were very keen to sell down their equities. They were right on the election outcome but wrong about how this would affect share markets as they rose the next day and thereafter.”

But there is the risk of a downturn if something spectacular happens with US President Donald Trump’s impeachment. Trump’s reactive use of Twitter also has the potential to drive the market up and down, which could also impact ETFs that follow the major bourses.

Avoiding a climate catastrophe

Investments that track stocks affected by climate change are also facing risks this year.

“If traditional agricultural methods are impacted by changing and volatile weather, ETFs such as BetaShares’ Global Agriculture ETF, which invests in the biggest agricultural companies in the world, may be impacted if the underlying companies do not pivot to address climate change risk,” Gerrard adds.

Commenting on the potential for climate change to impact markets, Frost notes markets typically price in future events ahead of time.

“So a negative theme does not always result in poor outcomes and a positive theme does not always result in good outcomes. But markets can overestimate or underestimate events.

“So if the market has and continues to underestimate climate change risk you'd expect this to affect resources-related ETFs and the market in general.”

Turning to the many niche ETFs that have hit the market, Argyros says liquidity is a minor risk for these. “Some specialist ones don’t have enough liquidity. In a downtrend, there’s a chance there won’t be enough liquidity for investors to exit the market.”

Only time will tell whether this comes to pass during 2020.