There is no doubt that ETF's have been a dominant force in the investment world since their inception in the early 90's. Used by almost every money manager in one way or another, we have come to accept them in our everyday investing lives. So much so that many do not focus on the potential risks of an ETF.
Sure, ETF's are certainly cheaper than mutual funds, and most know that they are more tax efficient than mutual funds. There is no doubt that they are transparent, well structured and generally well designed. But, what risks are there in ETFs? There are many risks involved when considering ETFs, so today we will focus on a few big ones.
Market Risk- The first one is the biggest and most obvious risk involved when investing in ETF's, and that is market risk. The markets go up, and they also go down. Remember that ETFs are only a basket holding their underlying investments. So if you buy an S&P 500 ETF
On the surface risk - The second biggest risk investors face in ETFs is what I call the "On the surface risk". At last count there are more than 1,800 ETFs on the market at this very moment, and investors face many choices in whatever area of the market they want to invest. Back in the early 2000's, for instance, the difference between the best-performing "biotech" ETF and the worst-performing "biotech" ETF was as much as 18 percent. Why? One of those ETFs had a basket of stocks that were "next-gen genomics" companies looking to cure cancer, while the other one held tool companies servicing the life sciences industry. Now "on the surface" an investor would have though they were investing in biotech, which technically was true, but when you looked a little deeper at the basket of stocks, one could see the differences. The cancer curing ETF would later be deemed by the media as a "lottery play".
Complexity Risk - ETFs have done an amazing job opening up different areas of the market, from traditional stocks and bonds to commodities, currencies, options strategies and more. But is having easy access to these complex strategies a good idea? Not without doing your homework.
Some great examples are those ETF's that we mention almost every week in our update. Does the U.S. Oil ETF
These are complex products and aside from short term trading, investors should know the details of the ETF's performance goals and arrangement.