What Are the Biggest Risks When Investing in ETFs? (2024)

It can be really easy to get caught up in the hype about exchange-traded funds (ETFs). But investors should keep in mind that they come with many of the same risks as stocks and mutual funds, plus some risks that are unique to some ETFs.

Key Takeaways

  • ETFs are less risky than individual stocks because they are diversified funds. Their investors also benefit from very low fees.
  • Still, there are unique risks to some ETFs, including a lack of diversification and tax exposure.
  • Many of these risks can be minimized or avoided by choosing wisely among the many ETFs available.

Tax Risks of ETFs

Tax efficiency is one of the most promoted advantages of an ETF. But not all ETFs can boast this efficiency. The tax risk depends on how actively the ETF is managed. Not understanding the tax implications can add up to a nasty surprise in the form of a bigger-than-expected tax bill.

ETFs create tax efficiency by using in-kind exchanges with authorized participants (AP). This is different from how traditional mutual funds are managed. A mutual fund manager must sell stocks to cover redemptions. The manager of an ETF uses an exchange of an ETF unit for the actual stocks within the fund.

That means capital gains on the stocks are actually paid by the AP and not the ETF. You will not receive capital gains distributions at the end of the year.

However, once you move away from index ETFs there are more taxation issues. Actively managed ETFs may not do all of their selling via an in-kind exchange. They can actually incur capital gains, which would then need to be distributed to the fund holders.

ETFs that Have Tax Exposure

There are several broad types of ETFs that can produce capital gains distribtions. They include international ETFs and ETFs that use derivatives or invest in commodities

An international ETF may not have the ability to do in-kind exchanges. Some countries do not allow for in-kind redemption, thus creating capital gain issues.

If the ETF uses derivatives to accomplish their objective, there will be capital gains distributions. You cannot do in-kind exchanges for these types of instruments, so they must be bought and sold on the regular market. Funds that typically use derivatives are leveraged funds and inverse funds.

Finally, commodity ETFs have very different tax implications depending on how the fund is structured. There are three types of fund structures and they include grantor trusts, limited partnerships (LP) and exchange-traded notes (ETNs). Each of these structures have different tax rules. For example, if you are in a grantor trust for a precious metal you are taxed as if it were a collectible.

The takeaway is that ETF investors need to pay attention to what the ETF is investing in, where those investments are located and how the actual fund is structured. If you have doubts on the tax implications check with a tax advisor before investing.

There are products and databases that allow you to search ETFs that have exposure to certain securities. For example, according to VettaFi as of January 18, 2024, 327 ETFs have Apple Inc. as one of their top 15 holdings.

Trading Risks

One of the advantages of investing in ETFs is that they can be bought and sold like stocks. This also creates risks that can hurt your investment return.

First, it can change your mindset from investor to active trader. Once you start trying to time the market or pick the next hot sector it is easy to get caught up in regular trading. Regular trading adds cost to your portfolio, thus eliminating one of the benefits of ETFs, their low fees.

In any case, regular trading to try and time the market is really hard to do successfully. Even paid fund managers struggle to do this every year, with few beating the indexes. You would be better off sticking with an index ETF and not trading it.

Portfolio Risks

There are many types of risk that come with any portfolio, from market risk to political risk to business risk. With the wide availability of specialty ETFs it's easy to increase your risk across all areas and thus increase the overall riskiness of your portfolio.

Every time you add a single country fund you add political and liquidity risk. If you buy into a leveraged ETF you are amplifying how much you can lose if the investment crashes. You can also easily mess up your asset allocation with each additional trade that you make, thus increasing your overall market risk.

The ability to trade in and out of ETFs with many niche offerings makes it easy to lose sight of the balance and diversity that you need to protect your portfolio. You don't want to discover that after your portfolio suffers steep losses.

Tracking Error

Although rarely considered by the average investor,tracking errorscan have an unexpected material effect on an investor's returns. It is important to investigate this aspect of anyETFindex fund before investing.

The goal of an ETFindex fundis to track a specific market index, often referred to as the fund's target index. The difference between the returns of the index fund and the target index is known as the fund's tracking error.

Most of the time, the tracking error of an index fund is small, perhaps a few tenths of one percent. However, a variety of factors can conspire to open a gap of several percentage points between the index fund and its target index.

Checking a fund's tracking error over time can at least assure you of its historical performance.

Liquidity Risk

Not all ETFs have a large asset base or high trading volume. If you find yourself in a fund that has a large bid-ask spread and low volume you could run into problems with selling your shares. That pricing inefficiency could cost you more money and greater losses.

The other angle here is the inability to get out of a position quickly. A lack of liquidity can delay execution of a trade. This can be a critical error for those looking to exploit arbitrage opportunities or time their exit to a narrow window.

The most recent price an ETF traded at may not be the total cost to exit or enter your position. For ETFs that are illiquid, it may be more difficult and more expensive to acquire shares.

Concentration Risk

Many ETFs hone in on specific sectors, industries, or asset classes. This focus ties the ETF to the fortunes of that particular sector, for better or for worse.

Such ETFs lack some of the diversification that is one of the great benefits of ETFs and mutual funds.

Sector-specific economic and cyclical factors, combined with market and regulatory changes, add to the risk. Consider the cyclical flows in real estate. A real estate ETF may hold many assets, but as a whole their performance is dependent upon one industry.

Investors can reduce this risk by diversifying their portfolios across various sectors and asset classes. You can do this by investing in a mix of ETFs that include broad-market and multi-sector choices.

A good understanding of your risk tolerance is key when dealing with sector-specific ETFs. Make sure they're in line with your investment goals and risk comfort level, and evaluate how you'd feel if an entire industry were to collectively hit the skids.

Lack of Price Discovery

The increasing popularity of ETFs has some analysts worried.

If a preponderance of investors do not trade individual stocks but invest in index ETFs, price discovery for the stocks constitute and index may become less efficient.

In the worst case, if everybody owns just ETFs, then nobody is left to price the component stocks and thus the market breaks.

What Is Counterparty Risk and How Does It Relate to ETFs?

Counterparty risk comes into play when ETFs use derivatives such as futures or options. If the counterparty (the entity on the other side of the derivative contract) defaults, it can hurt the ETF's performance and the value of the assets it holds.

What Risks Are Linked to Dividend and Interest Rate Sensitivity in ETFs?

ETFs that focus on income, such as dividend or bond ETFs, can be sensitive to changes in interest rates. Rising interest rates can lead to lower bond prices, affecting the value of bond ETFs.

Keep in mind that the ETF may hold bonds with different lengths, each experiencing different rate risk.

Similarly, changes in dividend payments from underlying stocks influence dividend-focused ETFs. Companies can cancel or reduce their dividends at any time, meaning historical precedence may no longer be relied on for future cash flow.

Retirees or those that rely on this cash flow can be caught off guard should companies make this change.

What Are the Risks of Investing in Leveraged and Inverse ETFs?

Leveraged and inverse ETFs are designed for short-term trading and use complex strategies. These ETFs amplify market movements and can lead to substantial losses if they do not perform as expected.

In short, they are riskier and may not be suitable for long-term investors. Many of the risks listed above can be amplified by leveraged and inverse ETFs.

What Are the Risks of Overlapping Sector Exposure in ETF Portfolios?

Overlapping sector exposure occurs when multiple ETFs within a portfolio have significant positions in the same sectors. This lack of diversification can lead to heightened risk, as a downturn in a particular sector can have a more significant impact on the overall portfolio.

Be mindful of the largest holdings in each ETF you choose, or you may be less diversified than you think.

The Bottom Line

ETFs have become popular because of their many advantages, Still, investors must keep in mind that they aren't without risks. Know the risks and plan around them then you can take full advantage of the benefits.

What Are the Biggest Risks When Investing in ETFs? (2024)


What Are the Biggest Risks When Investing in ETFs? ›

ETFs have some structural advantages relative to mutual funds but it's important to remember that ETFs have risks like all investments. Five of the key ETF risks to consider include: market risk, tracking error, liquidity, sector concentration, and single-stock concentration.

What is the biggest risk in ETF? ›

1. Market risk. The single biggest risk in ETFs is market risk.

Why am I losing money with ETFs? ›

Interest rate changes are the primary culprit when bond exchange-traded funds (ETFs) lose value. As interest rates rise, the prices of existing bonds fall, which impacts the value of the ETFs holding these assets.

Why are ETFs considered to be low risk investments? ›

Thanks to their lower costs and ability to diversify a portfolio, ETFs are considered low-risk investments. That's not to say ETFs are not risk-free. They can be tax-inefficient, generate high trading fees, and have low liquidity.

What is the biggest risk associated with leveraged ETFs? ›

The two major risks associated with leveraged ETFs are decay and high volatility. High volatility translates to high risk. Decay emanates from holding the ETFs for long periods.

Has an ETF ever gone to zero? ›

Leveraged ETF prices tend to decay over time, and triple leverage will tend to decay at a faster rate than 2x leverage. As a result, they can tend toward zero.

What are the cons of ETF? ›

Disadvantages of ETFs
  • Higher Management Fees. Not all ETFs are passive. ...
  • Less Control Over Investment Choices. When you invest in an ETF, you're buying a basket of stocks intended to align with the fund's objectives. ...
  • May Not Beat Individual Stock Returns.
Sep 30, 2023

What happens to my ETF if Vanguard fails? ›

Vanguard is paid by the funds to provide administration and other services. If Vanguard ever did go bankrupt, the funds would not be affected and would simply hire another firm to provide these services.

Is an ETF safer than a stock? ›

Advantages of investing in ETFs

A well-diversified ETF such as one based on the S&P 500 can beat most investors over time, making it easy for regular investors to do well in the market. ETFs tend to be less volatile than individual stocks, meaning your investment won't swing in value as much.

What happens to ETFs in a recession? ›

Investors looking to weather a recession can use exchange-traded funds (ETFs) as one way to reduce risk through diversification. ETFs that specialize in consumer staples and non-cyclicals outperformed the broader market during the Great Recession and are likely to persevere in future downturns.

How safe is cash to ETFs? ›

Despite their appealing returns, these funds carry what is known as counterparty risk—the risk that a bank could fail to fulfill its obligations to investors. In other words, the safety of Cash ETFs is equal to the reliability of the banks which hold your money.

Is it safe to only invest in ETFs? ›

Key Takeaways. ETFs can be safe investments if used correctly, offering diversification and flexibility. Indexed ETFs, tracking specific indexes like the S&P 500, are generally safe and tend to gain value over time. Leveraged ETFs can be used to amplify returns, but they can be riskier due to increased volatility.

Is an ETF riskier than a mutual fund? ›

The short answer is that it depends on the specific ETF or mutual fund in question. In general, ETFs can be more risky than mutual funds because they are traded on stock exchanges.

Can ETFs go negative? ›

In other words, you could potentially be liable for more than you invested because you bought the position on leverage. But can a leveraged ETF go negative? No. If you own a leveraged ETF you can't lose more than your initial investment amount.

Can you hold ETFs long term? ›

Nearly all leveraged ETFs come with a prominent warning in their prospectus: they are not designed for long-term holding. The combination of leverage, market volatility, and an unfavorable sequence of returns can lead to disastrous outcomes.

Why are 3x ETFs wealth destroyers? ›

Expense ratios might seem like a minor concern, but they can eat away at your returns over time. Triple-leveraged ETFs tend to have alarmingly high expense ratios, often around 1% annually. In contrast, standard stock market index ETFs typically have expense ratios under 0.05%.

Are ETFs high risk? ›

ETFs are considered to be low-risk investments because they are low-cost and hold a basket of stocks or other securities, increasing diversification. For most individual investors, ETFs represent an ideal type of asset with which to build a diversified portfolio.

Are ETFs riskier than funds? ›

The short answer is that it depends on the specific ETF or mutual fund in question. In general, ETFs can be more risky than mutual funds because they are traded on stock exchanges.

What investment has the highest risk? ›

The 10 Riskiest Investments
  1. Options. An option allows a trader to hold a leveraged position in an asset at a lower cost than buying shares of the asset. ...
  2. Futures. ...
  3. Oil and Gas Exploratory Drilling. ...
  4. Limited Partnerships. ...
  5. Penny Stocks. ...
  6. Alternative Investments. ...
  7. High-Yield Bonds. ...
  8. Leveraged ETFs.

Is it safe to put all money in one ETF? ›

All-in-one ETFs or a one-fund portfolio are best for short- to mid-term goals because they are easier to manage and have lower risk in the short term. Examples of some goals you can use an all-in-one ETF include: Down payment.


Top Articles
Latest Posts
Article information

Author: Msgr. Refugio Daniel

Last Updated:

Views: 5293

Rating: 4.3 / 5 (74 voted)

Reviews: 81% of readers found this page helpful

Author information

Name: Msgr. Refugio Daniel

Birthday: 1999-09-15

Address: 8416 Beatty Center, Derekfort, VA 72092-0500

Phone: +6838967160603

Job: Mining Executive

Hobby: Woodworking, Knitting, Fishing, Coffee roasting, Kayaking, Horseback riding, Kite flying

Introduction: My name is Msgr. Refugio Daniel, I am a fine, precious, encouraging, calm, glamorous, vivacious, friendly person who loves writing and wants to share my knowledge and understanding with you.