Even though exchange-traded funds (ETFs) come with a lot of benefits, these investment vehicles still carry with them some inherent risks that are best to be avoided or controlled by the investor.
Tax Risks
Among the greatest talked-about advantages of ETFs is their apparent taxa efficiency. But while some types of ETFs come with great tax-related features, many other types actually do not have the touted tax efficiency.
As a matter of fact, if you fail to understand the implications of taxes on your ETF, you may be up for an expensive surprise.
These funds create tax benefits by utilizing in-kind exchanges with authorized participants. Rather than the fund manager selling stocks to cover redemptions (similar to what they do in mutual funds), the manager of an ETF uses the exchange of an ETF unit for the actual stocks within the fund.
This leads to a situation where the AP, not the fund, pays the capital gains on the stocks. As a result, you will not receive any capital gains distributions at the end of the year.
On the other hand, if you’re not using index ETFs, then there are more taxation issues that can potentially happen.
Trading Risks
One of the most beneficial aspects of investing in ETFs is its characteristics of behaving like a stock. On the other hand, this same characteristic also creates many risks that can dampen the investor’s investment returns.
For one, it can turn an investor into an active trader. There will be a time when you start timing the market or select a sector which is easy to get yourself caught up in.
That time, you will be trading regularly, and the costs will add up. You have just eliminated the benefits of ETFs, which is the low costs.
At the same time, trading regularly and attempting to time the market will be really difficult to do with consistent success.
On top of that risk, you also face some liquidity risks. Not all ETFs have large asset base or even a high trading volume.
If, for instance, you are trading a fund that has a wide bid/ask spread and low trading volume, you may find it extremely hard to close out your position.
Portfolio Risks
ETFs are usually used to diversify passive portfolio strategies. However, this isn’t always true.
Any portfolio can face many different types of risks, such as market risks, political risks, or business risks. With the rampant availability of specialty ETFs, it’s easy to mount up your risks across all areas. Therefore, you also increase your portfolio’s overall risks.
Every time that you invest a single country fund, you also add political and liquidity risk. In the same manner, if you invest in a leveraged ETF, you are amplifying the amount you will lose should the investment turns sour.
Moreover, it’s easy to mess up your asset allocation with every additional trade that you make. In other words, you also increase your overall market risks.
