ETFs are a great way to diversify your portfolio and save money on trading commissions. But they’re not perfect. There are several risks associated with ETFs, including market risk, trading risk, tax risk and liquidity risk. Let’s go through each one so you can understand how these investments work—and whether or not they’re right for you.
Market risk
Imagine you buy an ETF with a $100 price. The next day, the price drops to $80 but then rebounded and went back up to $120. This is called a “premium” because investors are paying more for the ETF than it’s worth.
If you bought into this ETF at $100 and now want to sell your shares, you might only receive $80 if there is a significant premium on them. This means that even though the fund has gone up in value by 20%, if the market price is below its net asset value (NAV) then investors will experience losses when they sell their shares at this premium price.
The opposite is also true. If there is a discount on an ETF, then this means that investors are selling their shares at less than the fund’s NAV. In this case, if you bought into the ETF at $100 and now want to sell your shares for $80 then you will experience gains when you sell them at this discount price.
Trading risk
In addition to their other fees, ETFs are traded on the market like any other security. This means that investors can buy or sell an ETF at a premium or discount to its net asset value (NAV).
The price of an ETF may be higher than its NAV because it is more liquid than the underlying assets. For example, if there are only 100 shares of an ETF available for sale on any given day and there are 2 million investors who want to buy them, then each share will cost $1 per share above its NAV.
ETFs can be bought and sold throughout the trading day and are often traded at a premium or discount to their NAV. This is similar to mutual funds, which are also traded on secondary markets. ETFs may pay dividends on their holdings or offer redemption features that allow investors to sell shares back into the fund by giving notice.
Tax risk
The tax risk for ETFs is the same as for stocks. If, after selling an ETF and receiving a distribution (dividend), your total taxable income for the year exceeds $200,000 or you’re married and filing separately with adjusted gross income (AGI) over $125,000, then any ETF distributions are considered ordinary dividends and may be taxed at ordinary rates rather than at lower long-term capital gains rates. The rate depends on your income tax bracket:
While this is one disadvantage of ETFs that can’t be avoided if you’re in a high enough tax bracket to take advantage of it—and if that’s the case it will likely be outweighed by your other gains and losses—it’s important to know how this might affect your portfolio so you can plan accordingly.
Tax loss harvesting Tax-loss harvesting, or simply “harvesting,” is the practice of selling investments that have declined in value to offset gains from other investments. Harvesting can help reduce your overall tax bill and provide additional income for retirement.
Liquidity risk
The more liquid an asset is, the more easily you can buy and sell it. It will also have a lower bid-ask spread, meaning you’ll get more bang for your buck on each trade. Liquidity risk is the risk that you won’t be able to buy or sell an ETF when you want to because there aren’t enough buyers or sellers at those prices. This can happen when an ETF has too few assets under management (assets), which could mean that the market isn’t big enough to support trading in large volumes of shares without affecting its price significantly; or if there aren’t enough market makers (investment firms) willing to facilitate trades between buyers and sellers at quoted prices.
Liquidity risk is a function of both size and frequency of trading: The larger an asset class grows within an ETF portfolio, typically due to inflows from investors, so does its liquidity—but only up until a certain point after which no further growth will occur without causing significant changes in valuation based on supply/demand dynamics (and potentially pushing investors out). Similarly, when there are fewer market makers available for these securities—whether due to regulatory constraints or simply because there’s less demand for them—that means fewer bids on either side of any given security’s quote price; thus increasing its bid-ask spread.
Regulatory & counterparty risk
ETFs are subject to the same regulations as mutual funds, stocks and bonds.
When you buy a stock or a bond, you’re taking on risk in two ways. First, there’s credit risk: if the company goes bankrupt and can’t repay what it owes you (the principal), then your investment is lost. Second, there’s market risk: if the stock price falls below what you paid for it (the market price), then you lose money on your investment too.
ETFs have much less credit risk because they don’t hold any assets directly; instead they own shares in other companies that represent those assets—known as underlying securities—and this means their value isn’t tied so closely to one particular company’s fortunes. This is partly why ETFs tend not to suffer from dramatic swings in price like individual stocks do—but it does mean that an ETF doesn’t offer investors quite as much upside potential either! It’s important to understand which type of fund is right for each stage of your journey toward financial independence so that no matter where life takes us next we’ll have plenty options available when its time for us.
There are several risks associated with ETFs, but there are also ways to mitigate and manage those risks.
As a broad investment tool, there are several risks associated with ETFs. However, there are also ways to mitigate and manage these risks.
Most investors use ETFs for their low cost and tax efficiency, but the funds themselves have a number of drawbacks that can result in losses or missed opportunities. The first disadvantage is that they’re not always easy to buy and sell like stocks or mutual funds; many times it’s necessary to call your broker if you want to make an adjustment with your holdings (like adding more money). In addition, it’s possible that an investor might not be able to sell an ETF at all—for example, if its value has fallen below $10 per share since purchase time due to market fluctuations outside of management control; this kind of situation usually occurs when volatile stocks drop rapidly after being purchased through an index fund like SPDR S&P 500 Trust (SPY).
ETFs also have a number of advantages over mutual funds and stocks, including tax efficiency (which means that investors don’t pay taxes on any capital gains or losses until they sell) and low cost (because they’re passively managed). It’s important to remember that ETFs are designed to mirror the performance of an index—not outperform it.
ETFs are great investment vehicles, but they’re not perfect. There are several risks associated with ETFs, but there are also ways to mitigate and manage those risks.
