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penninah

Risks associated with ETFs

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Hi,
After surveying various investments, I have decided to go for ETFs. I have no in-depth knowledge about them, and I need enlightenment on the risks, if any, that come with investing in ETFs.

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Hi Penninah,

You are on the right track since the most important thing after settling on an investment option is to find out the risks that come with it. Let's dive into the most common risks of ETFs.

  • Taxation risk

First, the taxation of an exchange trade investment keeps fluctuating, which can have negative effects. Additionally, the profit from ETFs attracts income tax instead of capital gains tax.

  • Composition risk

You can have two ETFs in the same sector and with the same names but with different holdings. This is usually the case if the construction of their indexes differs. As a result, these ETFs will have differing returns.

 

  • Additional costs risk

Apart from the standard costs like taxes and interest income, creation fees and capital gains, ETFs are also subject to other costs. These inexplicit costs include direct trading costs, sales charges, market impact costs and commissions. 

 

  • Tracking error risk 

This error occurs when a particular ETF fails to match its index. This can be caused by either high fees, the replication method applied, dividend timing or an unused cash balance. A tracking error is an important indicator of how the ETF performs.

 

  • The risk of closure 

Due to diminishing assets and a lack of interest by investors, many ETFs get liquidated or closed. on top of the closure, costs associated with the closure are also passed on to the investor

  • Risks in the market

ETFs are affected by market forces, just like other investments.

  • Counterparty risk

The majority of ETFs carry out swaps with a counterparty and lending out of securities and are therefore prone to counterparty risk. This means you stand to lose should the counterparty fail to honour their part of the bargain.

 

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