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.
