What Are ETF Risks? - Fidelity (2024)

In general, ETFs do what they say they do. But as with all investments, be sure to be aware of potential risks.

ETF.com

What Are ETF Risks? - Fidelity (1)

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 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 over 3,200 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 track the price of crude oil? No, not exactly. Does the ProShares Ultra QQQ ETF —a 2X leveraged ETF—deliver 200% of the return of its benchmark index over the course of a year? No, it does not.

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 holds gold bars and tracks the price of gold almost perfectly. If you buy GLD and hold it for one year, will you pay the favorable long-term capital gains tax rate when you sell?

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 110 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. 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.

8. 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.

9. 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.

10. 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 $12 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.

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.

What Are ETF Risks? - Fidelity (2024)

FAQs

What is ETFs 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.

What is a potential drawback of investing in an ETF? ›

ETFs are baskets of stocks or securities, but although this means that they are generally well diversified, some ETFs invest in very risky sectors or employ higher-risk strategies, such as leverage.

Are ETFs riskier than mutual funds? ›

In terms of safety, neither the mutual fund nor the ETF is safer than the other due to its structure. Safety is determined by what the fund itself owns. Stocks are usually riskier than bonds, and corporate bonds come with somewhat more risk than U.S. government bonds.

What is an ETF fidelity? ›

An exchange-traded fund (ETF) is a basket of securities you buy or sell through a brokerage firm on a stock exchange.

What is the biggest risk in ETF? ›

The single biggest risk in ETFs is market risk.

What is ETF in simple terms? ›

ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.

Are Fidelity ETFs worth it? ›

ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.

Has an ETF ever gone to zero? ›

Leveraged ETF prices tend to decay over time, and triple leverage will tend to decay at a faster rate than 2x leverage. As a result, they can tend toward zero.

Are ETF investments risky? ›

ETFs can be safe investments if used correctly, offering diversification and flexibility. Indexed ETFs, tracking specific indexes like the S&P 500, are generally safe and tend to gain value over time. Leveraged ETFs can be used to amplify returns, but they can be riskier due to increased volatility.

What happens if ETF goes bust? ›

Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF. Receiving an ETF payout can be a taxable event.

Why choose an ETF over a mutual fund? ›

ETFs and index mutual funds tend to be generally more tax efficient than actively managed funds. And, in general, ETFs tend to be more tax efficient than index mutual funds. You want niche exposure. Specific ETFs focused on particular industries or commodities can give you exposure to market niches.

Is it better to hold mutual funds or ETFs? ›

The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs. If you worry about the impact of commissions and spreads, go with mutual funds.

What is Fidelity's best performing ETF? ›

Fidelity Blue Chip Growth Fund (FBGRX)

One of Fidelity's top-performing funds, FBGRX is also one of its oldest. Dating back to 1987, FBGRX has managed to outperform the Russell 1000 Growth Index since inception, returning an annualized 12.9% versus 11.5%.

Is Vanguard or Fidelity better for ETFs? ›

Both Fidelity and Vanguard have a wide variety of low-cost mutual funds and ETFs. If you're simply looking at the options offered by each firm, Fidelity has more options available.

Are ETFs free on Fidelity? ›

Free commission offer applies to online purchases of Fidelity ETFs in a Fidelity brokerage account with a minimum opening balance of $2,500. The sale of ETFs is subject to an activity assessment fee (of between $0.01 to $0.03 per $1000 of principal).

Are ETFs high risk? ›

ETFs are considered to be low-risk investments because they are low-cost and hold a basket of stocks or other securities, increasing diversification.

What happens if ETF collapses? ›

ETFs may close due to lack of investor interest or poor returns. For investors, the easiest way to exit an ETF investment is to sell it on the open market. Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF.

Is ETF safer than stocks? ›

Because of their wide array of holdings, ETFs provide the benefits of diversification, including lower risk and less volatility, which often makes a fund safer to own than an individual stock. An ETF's return depends on what it's invested in. An ETF's return is the weighted average of all its holdings.

Is Investing in ETF good or bad? ›

ETFs are an effective investment vehicle that offer portfolio diversification and trading flexibility with relatively low expense costs. However, it's critical to consider their downsides before you proceed.

Top Articles
Latest Posts
Article information

Author: Jeremiah Abshire

Last Updated:

Views: 6107

Rating: 4.3 / 5 (74 voted)

Reviews: 89% of readers found this page helpful

Author information

Name: Jeremiah Abshire

Birthday: 1993-09-14

Address: Apt. 425 92748 Jannie Centers, Port Nikitaville, VT 82110

Phone: +8096210939894

Job: Lead Healthcare Manager

Hobby: Watching movies, Watching movies, Knapping, LARPing, Coffee roasting, Lacemaking, Gaming

Introduction: My name is Jeremiah Abshire, I am a outstanding, kind, clever, hilarious, curious, hilarious, outstanding person who loves writing and wants to share my knowledge and understanding with you.