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.

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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 Are ETF Risks? - Fidelity? ›

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.

What is the downside to an ETF? ›

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

Is Fidelity good for ETF? ›

Fidelity's actively managed ETFs seek better investing outcomes* and offer trading flexibility along with potential tax efficiency. *While active ETFs offer the potential to outperform an index, these products may more significantly trail an index as compared with passive ETFs.

Is my money safe in an ETF? ›

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.

Are ETFs low or 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. For most individual investors, ETFs represent an ideal type of asset with which to build a diversified portfolio.

What happens if ETF goes bust? ›

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.

How are ETFs risky? ›

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.

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.

Do Fidelity ETFs have fees? ›

$0.00 commission applies to online U.S. equity trades, exchange-traded funds (ETFs) and options (+ $ 0.65 per contract fee) in a Fidelity retail account only for Fidelity Brokerage Services LLC retail clients. Sell orders are subject to an activity assessment fee (from $0.01 to $0.03 per $1,000 of principal).

Is my money safe at Fidelity? ›

Protecting your assets

With our Customer Protection Guarantee, we reimburse you for losses from unauthorized activity in your accounts. We also participate in asset protection programs such as FDIC and SIPC to help provide the best service possible.

Has an ETF ever gone to zero? ›

Theoretically, for exotic ETFs, yes — but as a practical matter highly unlikely. And for broad market ETFs that track something like the S&P 500 Index the probability of going to zero is, well, about zero. Every stock in the index would have to go to zero.

What is the biggest risk in ETF? ›

The single biggest risk in ETFs is market risk.

Can I withdraw ETF anytime? ›

Some funds, such as money market funds or certain exchange-traded funds (ETFs), are highly liquid and allow for same-day or next-day withdrawals. On the other hand, certain alternative investment funds or funds with lock-up periods may have limited liquidity, making it difficult to withdraw your money immediately.

Why I don't invest in ETFs? ›

ETFs are most often linked to a benchmarking index, meaning that they are often not designed to outperform that index. Investors looking for this type of outperformance (which also, of course, carries added risks) should perhaps look to other opportunities.

What happens to my ETF if Vanguard fails? ›

If Vanguard ever did go bankrupt, the funds would not be affected and would simply hire another firm to provide these services.

Why am I losing money with ETFs? ›

Interest rate changes are the primary culprit when bond exchange-traded funds (ETFs) lose value. As interest rates rise, the prices of existing bonds fall, which impacts the value of the ETFs holding these assets.

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