What risks are there with ETFs?

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ETFs are bringing tremendous innovation to investment management but as with any investment vehicle they’re not without their risks.

It’s important that investors understand the risks of using (or misusing) ETFs; let’s walk through the top 10.

1. Market risk

The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50 percent, nothing about how cheap, tax efficient or transparent an ETF is will help you.

2. "Judge a book by its cover" risk

The second biggest risk we see in ETFs is the "Judge A Book By Its Cover" risk. With more than 1,600 ETFs on the market today, investors face many choices in whatever area of the market they're choosing. For instance, the difference between the best-performing "biotech" ETF and the worst-performing "biotech" ETF is often vast.

Why? One biotech ETF might hold next-gen genomics companies looking to cure cancer, while the other might hold tool companies servicing the life sciences industry. Both biotech? Yes. But they mean different things to different people.

3. Exotic-exposure risk

ETFs have done an amazing job opening up different areas of the market, from traditional stocks and bonds to commodities, currencies, options strategies and more. But is having easy access to these complex strategies a good idea? Not without doing your homework.

For example, does the U.S. Oil ETF USO track the price of crude oil? No, not exactly. Does the ProShares Ultra QQQ QLD ETF—a 2X leveraged ETF—deliver 200 percent of the return of its benchmark index over the course of a year? No, it does not.

In general, as you move beyond plain-vanilla stock and bond ETFs, complexity reigns. Caveat emptor.

4. Tax risk

The "exotic" risk carries over to the tax front. The SPDR Gold Trust GLD holds gold bars and tracks the price of gold almost perfectly. If you buy GLD and hold it for one year, will you pay the favorable long-term capital gains tax rate when you sell?

You would if it were a stock. But even though you buy and sell GLD like a stock, you're taxed based on what it holds: gold bars. And from the perspective of the Internal Revenue Service, gold bars are a "collectible." That means you pay 28 percent tax no matter how long you hold them.

Currencies are treated even worse. Again, as you move beyond stocks and bonds, caveat emptor.

5. Counterparty risk

ETFs are for the most part safe from counterparty risk. Although scaremongers like to raise fears about securities-lending activity inside ETFs, it's mostly bunk: Securities-lending programs are usually over-collateralized and extremely safe.

The one place where counterparty risk matters a lot is with ETNs. As explained in "Exchange Traded Notes (ETNs)"Log In Required 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.

6. Shutdown risk

There are a lot of ETFs out there that are very popular, and there are a lot that are unloved. Each year, about 100 of these unloved ETFs get put out of their misery.

An ETF shutting down is not the end of the world. The fund is liquidated and shareholders are paid in cash. It's not fun, though. Often, the ETF will realize capital gains during the liquidation process, which it will pay out to the shareholders of record and that could mean an unnecessary tax burden. There will also be transaction costs, uneven tracking and various other grievances. One fund company even had the gall to stick shareholders with the legal costs of closing the fund (this is rare, but it did happen).

7. Hot new-thing risk

The ETF marketing machine is a mighty force. Every week—sometimes every day—it comes out with the new, new thing … one ETF to rule them all … a fund that will outperform the market with lower risk, all while singing the Star-Spangled Banner.

As Public Enemy warned: "Don't Believe the Hype."

While there are a lot of great new ETFs that come to market, you should be wary of anything promising a free lunch. Study the marketing materials closely, work to fully understand the underlying index's strategy, and don't trust any back-tested returns.

The rule of thumb says that the amount of money invested in an ETF should be inversely proportional to how much press it gets. That new Social Media/3-D Printing/Machine Learning ETF? It's not for the core of your portfolio.

8. Crowded trade risk

The "crowded trade risk" is related to the "hot new thing risk." Often, ETFs will open up tiny corners of the financial markets where there are investments that offer real value to investors. Bank loans are a great example. A few years ago, most investors hadn't even heard of bank loans; today, more than $10 billion is invested in bank-loan ETFs.

That's great…but be warned: As money rushes in, the attractiveness of a particular asset can diminish. Moreover, some of these new asset classes have limits on liquidity. If the money rushes out, returns may suffer.

That's not to warn anyone away from bank loans, or emerging market debt, or low-volatility strategies or anything else. Just be aware when you're buying: If this asset wasn't core to your portfolio a year ago, it should probably still be on the edge of your portfolio today.

9. ETF trading risk

Unlike mutual funds, 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. What's worse, an ETF's liquidity can be superficial: The ETF 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. Understand an ETF's liquidity before you buy, and always trade with limit orders.

10. Broken ETF risk

Most of the times, ETFs work just like they're supposed to: happily tracking their indexes and trading close to net asset value. But sometimes, something in the ETF breaks, and prices can get way out of whack.

Often, this is not the ETF's fault. When the Arab Spring occurred, the Egyptian Stock Exchange shut down for a period of weeks. The Market Vectors Egypt ETF (EGPT) was the only diversified, publicly traded way to speculate on where that market would open when things settled down. During the closure, Western investors were heavily bullish, bidding the ETF up sharply from where the market was before the revolution. But when Egypt opened back up again, the market was basically flat, and the ETF plummeted in value. It wasn't the ETF's fault, but investors did get burned.

We've seen this happen as well in ETNs or in commodity ETFs, when (for various reasons) the product has stopped issuing new shares. Those funds can trade up to sharp premiums, and if you buy an ETF trading at a significant premium, you should expect to lose money when you sell.

In general, ETFs do what they say they do and they do it well. But to say that there are no risks is to ignore reality. Do your homework.

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Article copyright 2014 by ETF.com. Reprinted with permission from ETF.com. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

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