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%, 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 nearly 3,000 U.S. listed ETFs on the market today (Source: Bloomberg), 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 US Oil ETF
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. For example, the SPDR Gold Shares ETF
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% 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), 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. Over the last 5 years, an average of 150 ETFs closed per year (Source: Bloomberg).
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."
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.
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 $15 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, utilize limit orders and avoid trading around the open and close of the market.
10. Broken ETF risk
Most of the time, 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, especially in international markets.
Often, this is not the ETF's fault. When the Athens Stock Exchange closed for over a month in the summer of 2015, Global X MSCI Greek ETF (GREK) traded at significant premiums to net asset value. If investors wanted to get out, they would expect to lose money 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 (Source: ETF.com).
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.