Exchange-traded funds, or ETFs, are passively managed investments tracking a particular index. They are an inexpensive way to gain exposure to broad sectors of the market, or to goose your portfolio with niche stocks on an exotic index.
The most obvious risk with ETFs is the riskiness of the assets in the underlying benchmark.
As passively managed funds, ETFs don’t have a portfolio manager taking active steps to hedge or mitigate risks. The assets are simply bought and sold in lockstep with the index more or less—if the benchmark drops 50%, so will the ETF.
This is an especially serious problem with leveraged ETFs, which aim to double or even triple the returns of the underlying index. For each $1 of capital invested, the fund maintains $2 or $3 of exposure to the benchmark using derivatives such as index futures and equity swaps. You can recognize these funds, because they have words like “ultra” or “enhanced” in their names, or simply use the 2X or 3X designation.
These funds are not meant to be used as long-term investments, and if you look at their performance over time, they almost always lose money. If you want to add them to your portfolio, always have an exit strategy in place. The SEC actually warns against their use for buy-and-hold investors.
Another risk for inexperienced investors lies in understanding the sectors and indices themselves. For example, in the biotech sector, there are indices tilted toward DNA, genomics, and genetic engineering (NYSE Arca Biotechnology Index) and others tilted toward healthcare equipment, technology, and facilities (NASDAQ U.S. Healthcare Innovators Index), and as you’d expect, the returns between the two are wildly different. ETFs tracking the Arca Biotech Index had year-to-date returns approaching 9%, while those tracing the Healthcare Innovators Index are in negative territory for the year.
Retail investors can also inadvertently end up overexposed to a particular stock, even in what appears to be a diversified portfolio. For example, a portfolio containing ETFs for large cap stocks, growth stocks, dividend stocks, value stocks, and low volatility stocks might appear balanced on quick inspection. Dig deeper into the securities in each of those indices, and you discover a single one, such as ExxonMobil, makes up a significant portion of each, giving you an unhealthy level of exposure to that particular stock.
Different tax treatments also pose a risk. While ETFs tend to be very tax efficient investments, the fund’s underlying assets matter. For example, the SPDR Gold Trust ETF holds actual bars of gold, which are treated as “collectibles” for tax purposes, and gains are taxed at 28%, regardless of how long the shares are held. There’s also special tax treatment for currency ETFs.
There is also a total lack of control over investments in an ETF. By definition, passively managed index investments follow the underlying benchmark as closely as possible. If a company on the index performs poorly, there’s no way to remove it from your portfolio without dumping the entire fund. Similarly, if you have moral objections to a particular company or industry represented on the index, you can’t divest of that stock without liquidating your entire position in the fund.
Perhaps the most pernicious risk with ETFs is they can turn investors into traders. Buying and selling in an attempt to “time the market” is a bad approach for investors, and the excess commissions wipe out the low fees, one of ETFs’ main advantages. Even if you’re buying proprietary funds through a brokerage account with no trading fees, you’ll still pay spread (the difference between the bid and ask price of the share) on your trades, which can be substantial for large trades.
ETFs do a great job of providing broad exposure to the market with low fees; they are often a good choice for long-term investors. But like all stocks, they are not without risk.