Key risks associated with investing in ETFs
All investing comes with risk, so what are the risks to be mindful of when it comes to ETFs?
One of the key benefits of ETFs is that they offer low-cost, direct exposure to a potentially diverse range of investments within a single trade. As with any investment, there are certain risks associated with ETFs, but it’s equally important to note on the flipside of these risks lies opportunity.
While media can overplay the numerous risks that can confront different types of ETFs at different times, it’s incumbent on you to approach these investments with your eyes wide open. While it’s always advisable to seek guidance from suitable qualified professionals before investing, here’s a snapshot of the key risks associated with ETFs for you to consider.
Not all ETFs were created equally: Some ETF structures carry greater risk, based on the underlying investment strategy they use, or the assets they invest in.
For example, while there are specific risks associated with fixed income or single-asset ETFs, the same is also true for those with leverage (borrowing) strategies. With that in mind, it’s important you understand the fund-specific risks associated with the ETFs you’re considering, and reading the product disclosure statement (PDS) is the best place to find out.
ETF returns are largely contingent on the success of the underlying stocks contained with the index or asset class they’re invested in. As a result, value tends to shrink and expand in line with share market fluctuations.
Beyond company-specific risks – like poor management or diminishing competitive advantage - the performance of the underlying stocks can also be effected by a myriad of external factors. These include what’s happening within local and global economies, like interest rates, and unemployment. Then there are natural disasters and geopolitical conflicts, which can also heighten market volatility.
ETFs can be exposed to liquidity risk, which depends on the amount of ETF units on offer to sell (or buy) relative to the amount you have to buy (or sell). A limit order can ensure you don’t sell below a certain desired price.
But the bigger risk is not being able to exit your investment, either at the price you want or - potentially following a major correction - at any price, due to an ETF being exposed to less liquid assets – and/or within a rapidly declining market.
Tax and regulatory risk
There’s always the risk of government introducing regulatory or tax changes directly impacting the value of companies in which the ETF invests, the value of the ETF units or the tax treatment of an ETF. Given that the tax treatment for ETFs may differ to shares, you should always seek advice that recognises your own financial circumstances.
Be mindful of any currency, economic or geopolitical risks associated with investing in global ETFs. For example, while a weak Australian dollar (A$) will increase the value of investments held in non-Australian dollars, a rising A$, will everything else being equal, decrease the value of investments held in other currencies.