It can be really easy to get caught up in the hype of how great exchange-traded funds (ETF) are. Yet they still come with many of the same risks as stocks and mutual funds, plus some unique risks for ETFs. Here's a look at the "fine print" for ETFs.
Tax efficiency is one of the most promoted advantages of an ETF. While certain ETFs, such as a U.S. Stock Equity Index ETF, come with great tax efficiency, many other types do not. In fact, not understanding the tax implications of an ETF you're invested in can add up to a nasty surprise in the form of a bigger-than-expected tax bill. (For more, see: ETFs or Mutual Funds: How to Know Which One to Use.)
ETFs create tax efficiency by using in-kind exchanges with authorized participants (AP). Instead of the fund manager needing to sell stocks to cover redemptions like they do in a mutual fund, the manager of an ETF uses an exchange of an ETF unit for the actual stocks within the fund. This creates a scenario where the capital gains on the stocks are actually paid by the AP and not the fund. Thus you will not receive capital gains distributions at the end of the year.
However, once you move away from index ETFs there are more taxation issues that can potentially happen. For example, actively managed ETFs may not do all of their selling via an in-kind exchange. They can actually incur capital gains which would then need to be distributed to the fund holders. (For more, see: How ETFs Fit Into Your Portfolio.)
If the ETF is of the international variety it may not have the ability to do in-kind exchanges. Some countries do not allow for in-kind redemption, thus creating capital gain issues.
If the ETF uses derivatives to accomplish their objective, then there will be capital gains distributions. You cannot do in-kind exchanges for these types of instruments, so they must be bought and sold on the regular market. Funds that typically use derivatives are leveraged funds, and inverse funds. (For more, see: What All Investors Should Know About ETFs.)
Finally, commodity ETFs have very different tax implications depending on how the fund is structured. There are three types of fund structures and they include: grantor trusts, limited partnerships (LP) and exchange-traded notes (ETN). Each of these structures have different tax rules. For example, if you are in a grantor trust for a precious metal you are taxed as if it were a collectible.
The takeaway is that ETF investors need to pay attention to what the ETF is investing in, where those investments are located and how the actual fund is structured. If you have doubts on the tax implications check with your tax advisor. (For more, see: What to Watch Out for When Using ETFs in a Portfolio.)
One of the most advantageous aspects of investing in an ETF is the fact that you can buy it like a stock. However this also creates many risks that can hurt your investment return.
First it can change your mindset from investor to active trader. Once you start trying to time the market or pick the next hot sector it is easy to get caught up in regular trading. Regular trading adds cost to your portfolio thus eliminating one of the benefits of ETFs, low fees. (For more, see: ETFs vs. Mutual Funds: The Lowdown on Fees.)
Additionally, regular trading to try and time the market is really hard to do successfully. Even paid fund managers struggle to do this every year, with most not beating the indexes. While you may make money you would be further ahead to stick with an index ETF and not trade it.
Finally, adding on to those excess trading negatives you subject yourself to more liquidity risk. Not all ETFs have a large asset base or high trading volume. If you find yourself in a fund that has a large bid-ask spread and low volume you could run into problems with closing out your position. That pricing inefficiency could cost you even more money and even incur greater losses if you can't get out of the fund in a timely fashion. (For more, see: Is Bigger Better with ETFs, Mutual Funds?)
Increased Portfolio Risk
There are many types of risk that come with a portfolio, everything from market risk to political risk to business risk. With the wide availability of specialty ETFs it's easy to increase your risk across all areas and thus increase the overall riskiness of your portfolio.
Every time you add a single country fund you add political and liquidity risk. If you buy into a leveraged ETF you are amplifying how much you will lose if the investment goes down. You can also quickly mess up your asset allocation with each additional trade that you make, thus increasing your overall market risk. (For more, see: Why the Top-Performing Fund Isn’t Often the Best Choice.)
By being able to trade in and out of ETFs with many niche offerings it can be easy to forget to take the time to ensure you are not too making your portfolio too risky. Finding this out would happen when the market is going down and there is not much you can do to fix it then.
The Bottom Line
ETFs have become so popular because of the many advantages they offer. Still, investors must keep in mind that they aren't without risks. Know the risks and plan around them then you can take full advantage of the benefits of an ETF. (For more, see: When is a Mutual Fund the Best Investment Option?)