Despite their diversification benefits, ETFs carry a number of specific risks. The risks associated with investing in ETFs are broadly classified as follows:
- Risk related to the Market: Despite their diversification benefits, ETFs are subject to market risk, just like stocks and other mutual funds. The larger the index that an ETF tracks, the lower the market risk, but it can never be completely eliminated.
- Liquidity risk: The liquidity of ETFs is composed of two components: the volume of ETF units traded on the exchange and the liquidity of individual securities in the portfolio. When the market is volatile, the ETF counter may have a wider bid-ask spread. Similarly, any security with insufficient liquidity in the index's portfolio may result in inefficient tracking, resulting in a difference in returns.
- Portfolio Risk: There are many different types of ETFs on the market, including international and exotic ETFs. As a result, choosing the right ETF to meet one's needs is critical to avoiding portfolio risks. Currency risk, counter-party risk, geopolitical risk, and sector-specific risks could be added to the portfolio risk.
- Risk related to structure: ETF structures vary depending on what they invest in and how they distribute capital gains from the portfolio. This may have an impact on the investor's tax liability. ETFs that use in-kind exchanges, for example, do not distribute capital gains to end investors, whereas ETFs that use derivatives or commodities may have complex structures and tax implications. ETFs are also subject to Tracking-Error, which means that their return will differ from the return of the underlying index because an ETF incurs expenses that the index does not.