The biggest ETF risk

It’s easy to fall into the hype about how great an exchange traded fund (ETF) is. However, they still have many of the same risks as stocks and mutual funds, plus some unique risks of ETFs. The following are the “rules” of ETFs.

Key points

  • ETFs are considered low-risk investments because of their low cost, holding a basket of stocks or other securities, and increasing diversification.
  • Nonetheless, holding ETFs may create unique risks, including special considerations for paying taxes based on the type of ETF.
  • For active traders of ETFs, additional market risks and specific risks may arise, such as the liquidity of the ETF or its components.

Tax risk

Tax efficiency is one of the most respected advantages of ETFs. Although some ETFs (such as US stock index ETFs) are highly tax efficient, many other types of ETFs do not. In fact, if you don’t understand the tax impact of the ETF you invest in, it will add annoying surprises in the form of tax bills that exceed expectations.

The ETF improves tax efficiency through physical exchange with authorized participants (AP). Unlike fund managers who need to sell stocks to pay redemption fees as in mutual funds, ETF managers use ETF units to exchange actual stocks in the fund. This creates a situation where the capital gains on stocks are actually paid by APs instead of funds. Therefore, you will not receive a capital gains distribution at the end of the year.

However, once you stay away from index ETFs, more tax issues may arise. For example, an actively managed ETF may not make all sales through the physical exchange. They can actually generate capital gains, which then need to be distributed to fund holders.

Tax risk of different ETF types

If the ETF is an international product, it may not be able to conduct physical exchange. Some countries do not allow physical redemption, which causes capital gains problems.

If the ETF uses derivatives to achieve its goals, then there will be capital gains distribution. You cannot physically exchange these types of tools, so you must buy and sell them on the regular market. The funds that usually use derivatives are leveraged funds and inverse funds.

Finally, the tax impact of commodity ETFs is very different, depending on the structure of the fund. There are three types of fund structures. They include: grantor trusts, limited partnerships (LP), and exchange-traded notes (ETN). Each of these structures has different tax rules. For example, if you are a settlor trust for precious metals, you will be taxed as collectibles.

The conclusion is that ETF investors need to pay attention to the objects of ETF investment, the location of these investments, and the structure of the actual fund. If you have questions about tax implications, please consult your tax advisor.

Transaction risk

One of the most advantageous aspects of investing in an ETF is that you can buy it like stocks. However, this also creates many risks that may harm your return on investment.

First, it can transform your mindset from an investor to an active trader. Once you start trying to grasp the market timing or choose the next hot sector, it is easy to fall into regular trading. Regular trading will increase the cost of your investment portfolio, thereby eliminating one of the benefits of ETFs, which is low fees.

In addition, it is really difficult to succeed in trying to time the market through regular trading. It is difficult for even paid fund managers to do this every year, and most of them fail to outperform the index. Although you may make money, sticking to an index ETF instead of trading it will go further.

Finally, coupled with the negative effects of over-trading, you will expose yourself to more liquidity risks. Not all ETFs have a large asset base or high trading volume. If you find yourself in a fund with a large bid-ask spread and low trading volume, you may encounter problems when closing positions. If you cannot withdraw from the fund in time, this inefficiency in pricing may cost you more money and even incur greater losses.

Portfolio risk

ETFs are often used to diversify passive portfolio strategies, but this is not always the case. Any investment portfolio has many types of risks, from market risks to political risks to business risks. With the widespread use of professional ETFs, it is easy to increase your risk in all areas, thereby increasing the overall risk of your investment portfolio.

Every time a national fund is added, it increases political and liquidity risks. If you buy a leveraged ETF, you will magnify the amount you will lose when your investment drops. You can also quickly mess up your asset allocation by making each additional transaction, thereby increasing your overall market risk.

By being able to trade in ETFs with many niche products, it is easy to forget to take the time to ensure that your portfolio is not too risky. You will find this when the market goes down, and then there is nothing you can do.

Tracking error

Although the average investor rarely considers it, tracking errors can have an unexpectedly significant impact on investor returns. It is important to investigate this aspect of any ETF index fund before investing.

The goal of an ETF index fund is to track a specific market index, usually called the fund’s target index. The difference between the returns of the index fund and the target index is called the fund’s tracking error.

Most of the time, the tracking error of index funds is very small, perhaps only a few tenths. However, multiple factors sometimes combine to cause a gap of several percentage points between an index fund and its target index. To avoid such unwelcome surprises, index investors should understand how these gaps might develop.

Lack of price discovery

Some analysts worry that a risk that may arise is that the vast majority of investments will turn to passive index investments using ETFs. If most investors hold ETFs and do not trade individual stocks in them, the price discovery efficiency of the individual securities that make up the index may be low.In the worst case, if Everyone With only ETFs, no one can set prices for the constituent stocks, causing the market to collapse.

Bottom line

ETFs are so popular because they provide many advantages. However, investors must remember that they are not without risk. Understand the risks and plan around them, and then you can take full advantage of ETFs.

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