Four hazards, ranked by how often they actually hurt somebody.
What is the compounding trap in daily-rebalanced funds?
The compounding trap in leveraged and inverse funds is first because it is the only one on this list that is a certainty rather than a risk. A fund that promises two times the index's daily return delivers exactly that every day and something else entirely over any longer period. Rebalancing daily to a constant leverage means selling after falls and buying after rises, which loses money in a choppy market and makes money in a trending one. Over the ten-day path in Worked example 7 the index falls 1.789877%, twice that is a loss of 3.579753%, and the two-times fund loses 4.912423%. The 1.332669 point gap comes from neither a fee nor tracking error, but from the arithmetic of daily rebalancing. It scales with the square of volatility, and on a path with one tenth the daily moves the same gap is 0.013922 points, about one ninety-sixth as large. Indian mutual funds are not permitted to run leveraged or inverse schemes, so this is a hazard an Indian investor meets only through overseas products; the United States permits them and they are widely marketed. Verify the current Indian position with the Securities and Exchange Board of India before advising on it.
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What are the counterparty and securities-lending risks?
Counterparty risk in synthetic structures applies to funds that obtain the index return through a total-return swap rather than by holding the shares. The fund holds a collateral basket, pays its return away to a swap counterparty, and receives the index return. The exposure at any moment is the fund's net asset value minus the collateral posted, floored at zero. When collateral exceeds net asset value the exposure is nil, and the whole risk lives in the gap that opens when the collateral falls in a stress that also weakens the counterparty. European rules cap the exposure to a single counterparty at a fraction of net asset value, and the specific cap and the eligible-collateral rules are the sort of provision that gets revised; check the current text rather than a summary. The practical question for an analyst is simpler than the regulation: is the collateral basket correlated with the thing that would kill the counterparty?
Securities-lending risk is the price of the credit in the tracking difference page. The fund lends shares against collateral, and three things can go wrong: the borrower fails while the collateral is insufficient, the collateral itself is reinvested into something that loses money, or the shares are unavailable when the fund needs to vote or sell.
Read three disclosures before accepting the revenue. The fraction of the portfolio on loan, the collateral policy including what cash collateral is reinvested into, and the revenue split with the lending agent. A fund that keeps 60% of gross lending revenue and lends 5% of the portfolio is running a different business from one that keeps 85% and lends 40%.
What are closure and settlement risks?
Closure and settlement finish the list. Funds are liquidated when they fail to gather assets, which forces a taxable exit at a time the investor did not choose, and settlement mismatches between the units and the basket create financing costs that surface in the arbitrage band rather than in any fee table. Neither is dramatic and both are worth a line in a diligence note.