What ETF Risks Should You Know About?

Exchange-Traded Funds (ETFs) trade on stock exchanges, much like individual stocks. They typically hold a diversified basket of assets (stocks, bonds, or commodities) to track a specific index or sector. ETFs are popular due to their accessibility, diversification, and often lower expense ratios compared to mutual funds.

While ETFs offer advantages, they are not without risks. Like any investment, understanding these risks is important for making informed decisions. The specific risks associated with ETFs can vary based on their underlying holdings, trading mechanisms, and structural complexities.

Risks from Market Movements and Index Replication

ETFs are exposed to market risk, meaning their value can decline due to broad market downturns or poor performance of underlying assets. Even diversified ETFs cannot entirely escape systemic market volatility. For example, an ETF tracking the S&P 500 will see its value fall if the overall S&P 500 index declines, regardless of the ETF’s efficiency.

Tracking error risk refers to the divergence between an ETF’s performance and its target index. While ETFs aim to mirror their benchmarks as closely as possible, perfect replication is rarely achieved. Several factors contribute to tracking error, including the management fees and expense ratios charged by the ETF provider.

Methods an ETF uses to replicate an index can also introduce tracking error. Some ETFs employ a sampling strategy for large indexes, holding only a subset of the index’s securities, which can lead to slight deviations. Cash drag, where a portion of the fund’s assets is held in cash rather than invested, and differing dividend reinvestment policies between the ETF and its index can also cause discrepancies.

Risks from Trading and Liquidity

ETFs’ trading characteristics introduce risks related to their buying and selling on an exchange. Liquidity risk is a concern, as less popular or specialized ETFs may have lower trading volumes. This can make it challenging for investors to buy or sell shares quickly without impacting the price, especially during periods of market stress.

Lower liquidity often leads to wider bid-ask spreads—the difference between the highest price a buyer will pay (bid) and the lowest price a seller will accept (ask). A wider spread translates to higher trading costs for investors, as they effectively pay more to buy and receive less when selling. For example, a thinly traded ETF might have a spread of several cents or more, while a highly liquid one could have a spread of just a penny.

An ETF’s market price can also 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, calculated at the end of each trading day. Because ETFs trade continuously like stocks, their market price can fluctuate above or below this NAV due to supply and demand.

This premium or discount can be more pronounced during periods of high market volatility or for ETFs holding less liquid underlying assets. While arbitrage mechanisms generally work to keep the market price close to NAV, significant deviations can occur, potentially impacting an investor’s effective purchase or sale price.

Risks of Specialized ETF Structures

Some ETFs employ complex structures or focus on niche areas, introducing unique risks. Leveraged and inverse ETFs amplify returns or provide the opposite return of an index, typically daily. For example, a 2x leveraged ETF delivers twice the daily return of its benchmark, while an inverse ETF provides the opposite daily return.

The compounding effect of daily rebalancing makes these funds generally unsuitable for long-term holding. Over periods longer than a single day, their performance can deviate significantly from the stated multiple of the underlying index, potentially leading to substantial losses even if the benchmark moves favorably over time. This effect is particularly pronounced in volatile markets.

Concentration risk arises in ETFs focused on a specific sector, industry, or a small number of securities. While offering targeted exposure, this lack of diversification can expose investors to higher volatility and specific risks associated with that narrow focus. For example, a technology sector ETF might have a large percentage of its assets in just a few major tech companies, making its performance heavily dependent on those specific companies.

Synthetic ETFs do not directly hold underlying assets but use financial instruments like swap agreements to replicate index performance. This introduces counterparty risk: the financial institution providing the swap might default on its obligations. Although often mitigated by collateral and diversification among multiple counterparties, this risk exists.

For ETFs investing in foreign assets or markets, currency risk is an additional consideration. Fluctuations in exchange rates between the investor’s home currency and the foreign currency can impact returns when converting gains or losses back. For example, a strong U.S. dollar can reduce returns from international investments when converted back to dollars, unless the ETF employs currency hedging strategies to mitigate this exposure.