ETFs Can Be Safe Investments If Used Correctly

For those new to the investing game, there tends to be a lot of mystery surrounding exchange-traded funds (ETFs). While it is true that investors take on added risk if they do not fully understand the nature of their investments or the typical price action that accompanies them, ETFs do not typically offer a greater degree of risk than similar index-based funds.

There is nothing inherently risky with ETFs in general. However, because they trade like individual stocks, a skilled investor can actually implement investment strategies with added diversification, and therefore decreased risk, when used correctly. Like any investment product, there are some ETFs that are riskier than others, so it is important to understand which funds take on more risk in search of greater opportunity and which ones target more stable returns.

ETFs: The Basics

For investors who are not familiar with ETFs, a little primer is in order. ETFs are much like mutual funds but with some notable differences. Like mutual funds, ETFs invest in a wide range of securities and provide automatic diversification to shareholders. Rather than purchasing shares of an individual stock, investors purchase shares in the ETF and are entitled to a corresponding portion of its total value.

Unlike mutual funds, however, ETFs are traded on the open market like stocks and bonds. While mutual fund shareholders can only redeem shares with the fund directly, ETF shareholders can buy and sell shares of an ETF at any time, completely at their discretion.

ETFs are popular investments because they are relatively inexpensive and can be easily bought and sold. In addition, they carry fewer fees than other types of investments, provide a high level of transparency, and are more tax-efficient than comparable mutual funds.

A Safe Bet: Indexed Funds

Most ETFs are actually fairly safe because the majority are index funds. An indexed ETF is simply a fund that invests in the exact same securities as a given index, such as the S&P 500, and attempts to match the index's returns each year. While all investments carry risk and indexed funds are exposed to the full volatility of the market—meaning if the index loses value, the fund follows suit—the overall tendency of the stock market is bullish. Over time, indexes are most likely to gain value, so the ETFs that track them are as well.

Because indexed ETFs track specific indexes, they only buy and sell stocks when the underlying indexes add or remove them. This cuts out the necessity for a fund manager who picks and chooses securities based on research, analysis or intuition. When choosing mutual funds, for example, investors must spend a substantial amount of effort researching the fund manager and the return history to ensure the fund is managed properly. This is not an issue with indexed ETFs; investors can simply choose an index they think will do well in the coming year.

A Serious Gamble: Leveraged Funds

Though the majority of ETFs are indexed, a new breed of investment has cropped up that is much riskier. Leveraged ETFs track indexes, but instead of simply investing in the indexed assets and letting the market do its work, these funds utilize large amounts of debt as they attempt to generate greater returns than the indexes themselves. The use of debt to increase the magnitude of profits is called leverage, giving these products their name.

Essentially, leveraged ETFs borrow a given amount of money, usually equal to a percentage of the equity funds generated from shareholder investment, and use it to increase the amounts of their investments. Typically, these funds are called "2X," "3X," or "Ultra" funds. As the names imply, the goal of these funds is to generate some multiple of an index's returns each day. If an index gains 10%, a 2X ETF gains 20%. While this seems like a great deal, the value of a leveraged ETF can be extremely volatile because it is constantly shifting as the value of the underlying index changes. If the index takes a dive, the fund's value can take a serious beating.

Assume you invest $1,000 in a 3X ETF and the underlying index gains 5% on the first day. Your shares gain 15%, increasing the value to $1,150. If the index loses 5% the following day, however, your shares lose 15% of the new value, or $172.50, dropping the value of your shares down to $977.50.

If the underlying indexes gain consistently each day, these ETFs can be huge moneymakers. However, the market is rarely so kind, making leveraged ETFs some of the riskier investments on the market.