Risks of ETFs Every Investor Should Understand

Investing in ETFs can be a great way to diversify your portfolio, but it's essential to understand the potential risks involved. A key risk is that ETFs can be highly volatile, with their values fluctuating rapidly in response to market changes.

One ETF can hold a vast array of assets, making it difficult to predict its performance. This is particularly true for ETFs that track complex indexes or sectors.

Investors should be aware that ETFs can be prone to tracking errors, where the fund's performance deviates from the underlying index. This can be due to various factors, including differences in methodology or data sources.

Investors who don't regularly monitor their ETF holdings may be caught off guard by significant price swings.

ETFs can involve higher complexity and risk, especially those offering exposure to complex strategies or non-traditional asset classes.

Disruptions to ETFs can occur, causing prices to deviate significantly from their net asset value, impacting investor returns. This is often due to issues in international markets.

In some cases, ETFs can trade at significant premiums to net asset value, especially in international markets or when underlying securities are not available.

Market risks are a major concern for investors in ETFs. Market risk is the single biggest risk in ETFs, where the overall stock market has been affected negatively, and it may invariably affect the prices of the Equity ETF that have bought in the stocks.

If the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you. This is because ETFs are only an investment vehicle, a wrapper for their underlying investment.

Disruptions can occur in international markets, causing ETF prices to deviate significantly from their net asset value, impacting investor returns. This is known as broken ETF risk.

In extreme cases, like when the Athens Stock Exchange closed for over a month in the summer of 2015, Global X MSCI Greek ETF traded at significant premiums to net asset value, leaving investors with a loss when they sold.

Market prices of the underlying securities were not available while the market was closed, so the ETF had to be priced with the information available, which was limited.

The truth about ETFs is that they're not entirely risk-free. Data from Morningstar Direct and FactSet shows that some ETFs can be just as volatile as individual stocks.

The Lehman Brothers ETN fallout is a prime example of this. In 2008, the collapse of Lehman Brothers led to a 90% decline in the value of one particular ETN, which was backed by the failed investment bank's debt.

The risks of ETFs are often downplayed, but the numbers don't lie. The Lehman Brothers ETN fallout resulted in investors losing millions of dollars.

ETFs, ETNs, and ETPs can be confusing, but let's break it down. An exchange-traded fund (ETF) is like a basket of securities, such as stocks, bonds, or commodities, that trades on an exchange like a stock.

ETFs are structured as separate investment companies, limited partnerships, or trusts, which means they're independent from the company that manages them. This is important because if the parent company goes out of business, the ETF's assets are still safe.

ETNs, on the other hand, are bonds issued by large banks or financial institutions. They promise to pay ETN holders the return on an index over a certain period of time and return the principal at maturity.

But here's the thing: if the issuer of the ETN goes bankrupt, ETN holders could be left with a worthless investment or one that's worth much less. This is a risk that investors should be aware of.

ETNs are not overseen by a board of directors, unlike ETFs. Instead, the issuer makes decisions about the management of the ETN based on the rules in the prospectus and pricing supplements. This lack of oversight can be concerning.

Tax implications can be a unique risk for ETFs, with different tax treatment depending on the underlying assets.

Tax rules related to an ETF's holdings can be complex, especially when dealing with foreign companies or complex financial instruments like derivatives.

Investors need to carefully scrutinize the history of returns provided by the ETFs and tax consequences on such returns to ensure tax efficiency and avoid overpayment of taxes.

Tax liability in commodity ETFs is calculated differently depending on the fund's structure, and investors should be aware of these differences to minimize tax costs.

Foreign exchange can impact your investments, especially if you hold securities denominated in a foreign currency. Currency fluctuations can amplify gains or losses in such investments.

If you invest in an ETF that holds foreign securities, changes in foreign exchange rates can occur. This is a key consideration when investing abroad.

Currency fluctuations can be unpredictable and may affect your returns. It's essential to be aware of this risk before investing in foreign securities.

Inflation can erode the value of an ETF's underlying assets, affecting its overall performance.

Rising prices over time can reduce the purchasing power of returns, making it harder to achieve investment goals.

Inflation is a general risk associated with all investments, not just ETFs.

This means that investors should consider inflation when evaluating an ETF's potential for long-term growth.

Counterparty risk is relatively low for ETFs, but it's a different story for ETNs. ETFs are mostly safe from counterparty risk because securities-lending programs are usually over-collateralized and extremely safe.

The one place where counterparty risk matters a lot is with ETNs. ETNs are simply unsecured debt notes backed by an underlying bank. If the bank goes out of business, you're stuck waiting in line along with everyone else they owe money to.

Tax implications can be a major concern for ETF investors. Some ETFs are subject to different tax treatment due to their underlying assets.

ETFs can offer lower tax liability, which is a significant advantage. However, investors need to be aware of the tax implications on investment returns to avoid overpayment of taxes.

Tax liability can get complicated, especially when ETFs hold stocks of foreign companies or complex financial instruments like derivatives. Leveraged and inverse funds can also increase tax liability.

Funds using derivative instruments are taxed differently than those that don't. Commodity ETFs have unique tax structures that investors should be aware of.

Investors should carefully scrutinize the history of returns provided by the ETFs and tax consequences on such returns to ensure tax efficiency. This will help them avoid unnecessary tax burdens.

Gold ETFs, like the SPDR Gold Shares ETF, can be taxed as collectibles, resulting in a higher tax rate of 28% regardless of holding period. This is different from stocks, which are taxed based on holding period.

Tax and Regulatory issues can impact your investment in ETFs, and it's essential to be aware of them.

ETFs can shut down due to operational challenges or unprofitability, resulting in capital gains realization and transaction costs for shareholders.

This can be a significant inconvenience, especially if the ETF realizes capital gains during the liquidation process, which it will then pay out to shareholders of record.

You may also face unnecessary tax burdens due to these capital gains.

Transaction costs, uneven tracking, and other grievances are also possible.

Trading and investment in ETFs can be tricky, especially when it comes to trading costs. These costs can quickly eat into your returns.

Spreads between buying and selling prices can vary, impacting trading costs. An ETF's liquidity can also change, affecting the ease of trading. You need to consider trading costs while investing.

Even highly paid fund managers struggle to perfectly time the market, making it crucial to understand an ETF's liquidity before buying. This will help you avoid trading around the open and close of the market, where spreads can be wider.

Trading can be a complex and unpredictable aspect of investing, and ETFs are no exception. Trading costs can quickly eat into your returns, with spreads varying from one penny to many dollars.

ETFs may have varying spreads between buying and selling prices, impacting trading costs. Liquidity levels can change, affecting the ease of trading ETFs. It’s crucial to consider trading costs while investing.

You can't always buy an ETF with zero transaction costs. Like any stock, an ETF has a spread, which can vary from one penny to many dollars. Spreads can vary over time as well, being small one day and wide the next.

Trading around the open and close of the market can be particularly costly. Utilize limit orders to help manage your trading costs and avoid these high-risk times.

Liquidity risk is a real concern for ETFs, especially during unfavorable market conditions. There might be instances where it’s challenging to buy or sell shares in an ETF due to limited market liquidity or other external factors.

ETFs may trade one penny wide for the first 100 shares, but to sell 10,000 shares quickly, you might have to pay a quarter spread. Trading costs can quickly eat into your returns.

The ETF marketing machine can be a mighty force, promising new and exciting investment opportunities. However, be wary of anything promising a free lunch. Study the marketing materials closely, work to fully understand the underlying index's strategy.

An ETN can be a low-risk investment option because it promises to pay exactly the return on an index, minus its own expenses. This means there's little risk of tracking error, and the ETN should closely match the performance of the index.

Some ETNs offer unique investments that aren't available in an ETF framework. This can be attractive to investors who are committed to a specific niche investment.

ETNs can also have attractive tax consequences. Investors typically pay taxes on their investment only when they sell it for a gain or when the ETN matures.

Leveraged ETFs are designed to multiply the daily returns of an underlying index, but they can decay over time due to daily resets. This means that even if the underlying asset remains stable, the leveraged ETF can move away from its true performance.

Decay becomes more prominent the longer you hold a leveraged ETF. While the effects may be minimal in the short term, they can compound over time and lead to an unexpected deviation from the underlying asset.

If Apple's stock goes up by 5% over two weeks, we would expect a 2x leveraged ETF to be at 10%. However, due to decay, the actual return could be less than 10% due to daily rebalancing.

The effects of decay can be subtle, but they can add up over time. For example, if a 2x leveraged ETF drops by 2% one day, it will drop by 4%, and if it drops by 2% the next day, it will drop by 5.6%.

To manage decay risk, it's essential to have clear targets for entry and exit points before investing in a leveraged ETF. This means considering the reduced time horizon when developing a strategy and pricing targets for a potential short-term move.

Here are some examples of leveraged ETFs that track the performance of popular stocks:

Leveraged ETFs are primarily used for short-term trading opportunities, and investors usually hold these funds for a day or two, sometimes up to 10-14 days on the longer side. In other words, these leveraged ETFs are not intended to be held for months or years on end.

Decay risk is a significant concern when holding leveraged ETFs for extended periods, as performance can drift away from the underlying asset over time.

Time decay compounds and becomes more noticeable the longer you hold onto an asset, making it a substantial risk to consider.

The decay incurred over a year of holding a leveraged ETF is much more noticeable and carries more risk than what an investor would experience in a week.

For many investors, the credit risk inherent in ETNs isn't worth it, as they often prioritize market exposure over evaluating a bond issuer's health.

Investors may find ETNs to be more trouble than they are worth, and it's essential to carefully consider the risks before adding them to a portfolio.

If you still think an ETN might make sense, check out the alert issued by The Financial Industry Regulatory Authority (FINRA) in July 2012 to inform yourself of the features and risks of ETNs.

Sector Concentration is a key consideration for investors, and it's essential to understand the risks involved. An ETF that focuses on a specific sector, such as energy or biotechnology, can experience higher price fluctuations due to the concentration of its holdings.

Investing in a concentrated sector can be like putting all your eggs in one basket - if the sector performs poorly, the ETF's value may drop significantly. An ETF that invests across multiple sectors, however, may offer more diversified risk, helping to spread out potential losses.

Investing can have a significant impact on your financial future, and it's essential to understand the implications before making a decision.

Investing can be a long-term process, requiring patience and discipline, as seen in the example of a 25-year-old who invested $5,000 in a retirement account and watched it grow to $100,000 by age 55.

The implications of investing can be both positive and negative, depending on the investment choices made. A 2019 survey found that 70% of investors who took a conservative approach to investing experienced lower returns compared to those who took a more aggressive approach.

Investing can also affect your lifestyle, with some investors using their returns to fund major purchases or pay off debts. For instance, a couple used their investment gains to buy a dream home.

Investing can also impact your relationships, particularly if you're investing with others, such as in a joint account or business venture. A 2020 study found that 60% of investors who invested with a partner experienced disagreements over investment decisions.

Investing can also have tax implications, with some investments generating tax liabilities that can eat into your returns. A tax expert noted that tax losses can be used to offset gains from other investments, but only up to a certain limit.

When diversifying your investments, consider the type of assets you're including in your portfolio. A portfolio focused solely on a specific kind of asset can be subject to portfolio risk.

This is because such assets have symmetrical return curves, making them vulnerable to significant events. A considerable event affecting that particular asset type can cause the portfolio to lose a substantial portion of its value quickly.

Portfolio risk comprises market, political, and business risks. These risks can be devastating to your investments.

Market risks are inherent in any investment, and can be exacerbated by a portfolio's narrow focus.

Tolerance is the ability of an investment to withstand market fluctuations and still perform well.

Investors should consider the tolerance of their investment portfolio to risk, as a mismatch can lead to significant losses.

A low-risk investment, such as a bond, may not be suitable for an investor who can tolerate higher market volatility.

In contrast, a high-risk investment, such as a stock, may be more suitable for an investor who can tolerate significant price fluctuations.

Investors should also consider their personal financial situation and risk tolerance when making investment decisions.

For example, an investor who is nearing retirement may not be able to afford significant losses and should therefore prioritize low-risk investments.

On the other hand, a younger investor may be able to afford more risk and therefore may be able to benefit from higher-risk investments.

Ultimately, assessing tolerance is a key consideration in investment decision-making.

Long-term holding of leveraged ETFs can be a recipe for disaster, as the performance of these ETFs can drift away from the underlying asset over time.

Time decay starts to compound and become more noticeable the longer you hold onto an asset, making it a substantial risk for investors.

The decay incurred over a year of holding a leveraged ETF is much more noticeable and carries more risk than what an investor would experience in a week.

This means that investors need to be aware of the risks associated with holding leveraged ETFs for extended periods and consider alternative investment strategies that can help mitigate these risks.

Investors may find ETNs to be more trouble than they are worth, as they often involve evaluating a bond issuer's health and business considerations.

Most investors turn to exchange-traded products to get exposure to a particular market segment, not to delve into issuer health or business considerations.

The Financial Industry Regulatory Authority (FINRA) issued an alert in July 2012 to inform investors of the features and risks of ETNs, titled "Exchange-Traded Notes—Avoid Unpleasant Surprises."

The credit risk inherent in an ETN isn't worth it for many investors, who may prefer to avoid the trouble altogether.