What Are the Key Risks of Investing in ETFs?

Exchange-Traded Funds, commonly known as ETFs, are a popular investment vehicle combining features of mutual funds and individual stocks. These funds typically hold diversified portfolios of assets like stocks, bonds, or commodities. Their shares trade on stock exchanges throughout the day, similar to individual company stocks. While ETFs offer benefits like diversification and liquidity, they also carry inherent risks that investors should understand.

Risks from Market Fluctuations

The value of an Exchange-Traded Fund can be significantly impacted by broad market movements, known as general market risk. Economic downturns, geopolitical instability, or shifts in investor sentiment can lead to declines across various asset classes, reducing an ETF’s value even if its underlying holdings are sound. This systematic risk affects nearly all investments and is not exclusive to ETFs.

Interest rate changes also pose a risk, particularly for bond-focused ETFs. When interest rates rise, the value of existing bonds with lower fixed interest payments falls, leading to a decline in bond ETF net asset value. Equity ETFs can also be indirectly affected as higher rates increase borrowing costs for companies, potentially impacting their profitability and stock prices.

Inflation risk erodes the purchasing power of an investor’s returns. Even if an ETF generates a positive nominal return, the real return after accounting for inflation may be lower or negative. This risk is pronounced for fixed-income ETFs, where fixed payments become less valuable over time as prices for goods and services increase. Investors must consider how rising inflation might diminish the effective yield or capital appreciation of their ETF holdings.

Currency risk applies to ETFs that invest in international assets or hold securities denominated in foreign currencies. Fluctuations in exchange rates can affect the value of these investments when converted back into the investor’s home currency. For example, if a U.S. investor holds an ETF tracking a European stock index and the Euro weakens against the U.S. Dollar, the investment’s value in U.S. Dollar terms will decrease, even if the underlying European stocks perform well.

Risks from ETF Structure

One risk inherent to Exchange-Traded Funds is tracking error, the divergence between an ETF’s performance and its benchmark index. This discrepancy can arise from factors like the ETF’s operating expenses and management fees, which subtract from returns. Additionally, many ETFs use a sampling strategy rather than holding every security in an index, which can introduce minor deviations from the index’s exact performance.

Rebalancing the ETF’s portfolio to align with index changes, and holding a small percentage of assets in cash for operational purposes, can also contribute to tracking error. While ETF providers aim to minimize this difference, a small tracking error, often ranging from 0.05% to 0.20% annually for highly liquid funds, is expected. For less liquid or more complex ETFs, tracking error can be higher, potentially reaching 0.50% or more depending on market conditions and index composition.

Another structural risk is the potential for an ETF’s market price to trade at a premium or discount to its Net Asset Value (NAV). The NAV represents the per-share value of the ETF’s underlying assets, while the market price is what investors pay on an exchange. Premiums occur when the market price is higher than the NAV, and discounts happen when it is lower, typically by a small percentage.

Authorized Participants (APs) help maintain this alignment through an arbitrage mechanism, creating or redeeming ETF shares to profit from price differences, theoretically keeping the market price close to the NAV. However, during extreme market volatility or for ETFs with illiquid underlying assets, this mechanism may not function efficiently, leading to wider premiums or discounts. An investor buying at a premium or selling at a discount could incur losses, even if the NAV of the underlying assets remains stable or increases.

Liquidity risk in ETFs has two components: the liquidity of the ETF shares themselves and the liquidity of the underlying securities held by the fund. While many large ETFs are highly liquid and trade frequently, offering narrow bid-ask spreads, smaller or more specialized ETFs may trade less often. This reduced trading volume can result in wider bid-ask spreads, effectively increasing the cost of buying or selling shares.

Even if an ETF’s shares are liquid, if its underlying assets are illiquid, such as certain corporate bonds or obscure international stocks, the ETF’s price might still deviate significantly from its NAV, particularly during stressed market conditions. Counterparty risk is another consideration, especially for ETFs that use derivatives like futures or swaps. This risk involves the possibility that the other party to a financial contract might default on its obligations, leading to a financial loss for the ETF and its investors. This risk also applies to ETFs that engage in securities lending, where the borrower might fail to return the securities or collateral.

Risks from Trading and Management

Since Exchange-Traded Funds trade on exchanges like individual stocks, they are subject to trading halts. These halts can occur due to extreme price volatility in the ETF or its underlying securities, or for regulatory reasons, preventing investors from executing trades. During a trading halt, investors cannot buy or sell ETF shares, which can be problematic if urgent liquidity is needed or if market conditions are rapidly changing.

Execution risk is present when buying or selling ETF shares, particularly for less liquid funds or during volatile market periods. An investor’s order may not be filled at the desired price, especially if using a market order. This can result in an adverse price execution where the investor pays more or receives less than anticipated. Using limit orders can help mitigate this risk but may result in the order not being filled at all.

While many ETFs are passively managed, aiming to track an index, a growing number are actively managed. Actively managed ETFs introduce managerial risk, where the manager’s investment choices might underperform the market or fail to achieve the fund’s stated objectives. Unlike passive ETFs, their performance relies heavily on the skill and judgment of the portfolio manager, and there is no guarantee their strategies will succeed.

Cybersecurity risk is a concern for all financial products, including ETFs. This risk involves the potential for cyberattacks targeting ETF providers, trading platforms, or brokerage firms. Such attacks could lead to unauthorized access to investor accounts, theft of data, or disruptions in trading systems, all of which could negatively impact investors. Financial institutions continuously invest in cybersecurity measures, but the threat remains persistent.

Risks from Specialized ETF Strategies

Certain specialized Exchange-Traded Funds employ strategies that introduce higher risk compared to traditional, broadly diversified ETFs. Leveraged ETFs use financial derivatives and debt to amplify the returns of an underlying index, often by a factor of 2x or 3x, for a single day. Inverse ETFs, sometimes called “short” or “bear” ETFs, also use derivatives to deliver the opposite returns of an index.

These complex products are designed for short-term trading and are not suitable for long-term holding due to daily rebalancing and compounding effects. Over periods longer than a day, their performance can deviate substantially from the stated multiple of the underlying index’s return, often leading to underperformance due to volatility decay. Investors can experience losses, even if their directional bet on the market is correct over a longer period, if the market experiences significant fluctuations.

Commodity ETFs expose investors to the risks of their underlying assets, such as agricultural products, metals, or energy. These markets are susceptible to volatility driven by supply and demand imbalances, geopolitical events, and weather patterns. Many commodity ETFs gain exposure through futures contracts, which introduce complexities like contango and backwardation. Contango, where future prices are higher than current spot prices, can lead to negative roll yield.

Sector or niche ETFs concentrate investments within a specific industry, theme, or geographic region, offering targeted exposure but also carrying concentration risk. Their performance is dependent on the fortunes of that particular sector or theme, making them more volatile than broadly diversified funds. For example, an ETF focused solely on renewable energy or biotechnology could experience swings based on regulatory changes, technological breakthroughs, or industry-specific economic conditions.

Cryptocurrency ETFs, which aim to provide exposure to digital assets like Bitcoin or Ethereum, present high volatility and technological risks. The prices of cryptocurrencies can fluctuate significantly within short periods, driven by speculative trading, regulatory news, and market sentiment. These ETFs also face regulatory uncertainty, as governments worldwide continue to develop frameworks for digital assets, which could impact their value and accessibility. They are also exposed to technological risks inherent in blockchain networks, such as security breaches or operational failures.

Citations

https://www.investopedia.com/articles/investing/032615/what-etf-premiumdiscount-means.asp
https://www.investopedia.com/terms/a/actively-managed-etf.asp
https://www.spglobal.com/spdji/en/documents/research/research-understanding-tracking-error-in-etfs.pdf