ETFs Can Be Safe Investments If Used Correctly (2024)

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.

Key Takeaways

  • ETFs can be safe investments if used correctly, offering diversification and flexibility.
  • Indexed ETFs, tracking specific indexes like the S&P 500, are generally safe and tend to gain value over time.
  • Leveraged ETFs can be used to amplify returns, but they can be riskier due to increased volatility.
  • Industry-specific ETFs, such as those tied to cryptocurrencies, carry specific risks related to the underlying assets.
  • Liquidity risk in ETFs arises when trading volumes are low, impacting bid-ask spreads.

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 , 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.

The SEC warns that an ETF share may trade at a premium for any number of reasons.

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.

Industry Specific ETFs

One inherent fact across ETFs and equity securities in general is that specific investments can be riskier than others based on the underlying company. One share of an ETF that tracks to the S&P 500 has a different risk profile than one share of an ETF that tracks to the Russell 2000.

One prime example of this is tied to Bitcoin ETFs. First approved in 2023 by the SEC, these ETFs that hold cryptocurrency have a much different risk and volatility profiled compared to other types of securities.

The fact that these ETFs that hold cryptocurrency is not made inherently riskier because they are held in an ETF form. Instead, investors should take caution that they may not be a safe investment based on what the ETFs are holding. The risky part highlighted by this is that an investor may not know all of the underlying securities being held in an ETF. For instance, you likely don't know off the top of your head the securities being held in the iShares Russell 2000 ETF.

Avoiding Liquidity Risk in ETFs

The last item we'll touch on regarding the safety of ETFs is liquidity risk. Liquidity risk in ETFs arises when trading volumes of the ETF's shares are low or when the underlying assets lack an abundance of available shares.

When an ETF is illiquid, it means there is a limited number of buyers and sellers in the market. This can be risky because it can potentially lead to wider bid-ask spreads. Investors may find themselves buying shares at a premium or selling at a discount, impacting the overall returns.

Investors can inadvertently run into liquidity risk in several ways. One common scenario is when investing in niche or less-traded ETFs that track specific sectors, industries, or regions. If investing safely is a top priority for you, consider staying away from smaller ETFs. These funds may have lower trading volumes, making it more difficult for investors to execute trades without affecting the market price.

To mitigate liquidity risk, investors can adopt a few strategies. As mentioned above, it is essential to choose ETFs with sufficient trading volumes. Investors can also diversify their ETF holdings across different asset classes to avoid overconcentration. last, keep an eye on how market conditions may impact the ETFs you hold; for example, if bad news comes out, be mindful there may be an abundance of people trying to sell the same ETF shares.

How Do ETFs Differ from Mutual Funds?

ETFs differ from mutual funds in their trading structure. While mutual funds are bought and sold through the fund company at the end of the trading day at the net asset value (NAV) price, ETFs are traded on stock exchanges like individual stocks. This allows investors to trade ETF shares at market prices throughout the trading day.

How Are ETFs Created and Redeemed?

ETF shares are created or redeemed through an "in-kind" process. Authorized participants (usually large institutional investors) facilitate this process by exchanging a basket of securities with the ETF issuer for new ETF shares.

What Is the Tracking Error in ETFs?

Tracking error in ETFs refers to the deviation in performance between the ETF and its benchmark index. It can result from factors such as fees, transaction costs, and the efficiency of the fund's replication strategy.

Are There Tax Implications When Investing in ETFs?

There can be tax implications when investing in ETFs. Capital gains taxes may result from the sale of ETF shares, and investors may also face potential distributions of capital gains or income from the fund if they've received dividends.

The Bottom Line

ETFs are investment funds traded on stock exchanges providing investors with a diversified portfolio. There's a number of risks to ETFs including market fluctuations, tracking errors, liquidity challenges, or leveraged strategies. However, there are opportunities for investors to remain safe by being mindful of these risks and taking appropriate action.

ETFs Can Be Safe Investments If Used Correctly (2024)


ETFs Can Be Safe Investments If Used Correctly? ›

ETFs can be safe investments if used correctly, offering diversification and flexibility. Indexed ETFs, tracking specific indexes like the S&P 500, are generally safe and tend to gain value over time. Leveraged ETFs can be used to amplify returns, but they can be riskier due to increased volatility.

How safe are ETF investments? ›

Key Takeaways. ETFs are less risky than individual stocks because they are diversified funds. Their investors also benefit from very low fees. Still, there are unique risks to some ETFs, including a lack of diversification and tax exposure.

Are ETFs a good investment? ›

Key Takeaways. ETFs are considered to be low-risk investments because they are low-cost and hold a basket of stocks or other securities, increasing diversification. For most individual investors, ETFs represent an ideal type of asset with which to build a diversified portfolio.

Are ETFs safer than stocks? ›

Are ETFs Safer Than Stocks? ETFs are baskets of stocks or securities, but although this means that they are generally well diversified, some ETFs invest in very risky sectors or employ higher-risk strategies, such as leverage.

Can an ETF fund fail? ›

ETFs may close due to lack of investor interest or poor returns. For investors, the easiest way to exit an ETF investment is to sell it on the open market. Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF.

Are ETFs more safe? ›

Summary. ETFs are not less safe than other types of investments, like stocks or bonds. In many ways, ETFs are actually safer, for instance thanks to their inherent diversification. And by choosing the right mix of ETFs, you can control the market risk to match your needs.

What is the safest investment? ›

The concept of the "safest investment" can vary depending on individual perspectives and economic contexts, but generally, cash and government bonds, particularly U.S. Treasury securities, are often considered among the safest investment options available. This is because there is minimal risk of loss.

What is the risk of cash to ETF? ›

Despite their appealing returns, these funds carry what is known as counterparty risk—the risk that a bank could fail to fulfill its obligations to investors. In other words, the safety of Cash ETFs is equal to the reliability of the banks which hold your money.

What are the benefits of an ETF? ›

ETFs can offer lower operating costs than traditional open-end funds, flexible trading, greater transparency, and better tax efficiency in taxable accounts. For nearly a century, traditional mutual funds have offered many advantages over building a portfolio one security at a time.

What are ETFs best for? ›

Benefits and considerations of ETFs
  • Diversification. ETFs give you an efficient way to diversify your portfolio, without having to select individual stocks or bonds. ...
  • Low cost. With Schwab, online listed ETF trade commissions are $0 per trade. ...
  • Trading flexibility. ...
  • Transparency. ...
  • Tax efficiency.

What happens if ETF collapses? ›

If you own ETF shares, you will receive cash equivalent to the value of your holding on the day of liquidation (not the value on the last day of trading).

Are ETFs riskier than funds? ›

Both are less risky than investing in individual stocks & bonds. ETFs and mutual funds both come with built-in diversification. One fund could include tens, hundreds, or even thousands of individual stocks or bonds in a single fund. So if 1 stock or bond is doing poorly, there's a chance that another is doing well.

What is the highest performing ETF? ›

100 Highest 5 Year ETF Returns
SymbolName5-Year Return
PSIInvesco Semiconductors ETF23.83%
ITBiShares U.S. Home Construction ETF23.78%
FBGXUBS AG FI Enhanced Large Cap Growth ETN23.63%
XHBSPDR S&P Homebuilders ETF21.97%
93 more rows

Why am I losing money with ETFs? ›

Interest rate changes are the primary culprit when bond exchange-traded funds (ETFs) lose value. As interest rates rise, the prices of existing bonds fall, which impacts the value of the ETFs holding these assets.

Has any ETF ever failed? ›

These ETFs had ample time to gather assets, but they failed to do so. The typical ETF was 8.5 years old but had only $25 million in AUM on average over the trailing 12 months before closure. Funds like Invesco DB Silver and Invesco DB Gold launched in 2007 but couldn't amass sufficient assets.

Do ETFs go down in a recession? ›

ETFs. Investment funds are a strategic option during a recession because they have built-in diversification, minimizing volatility compared to individual stocks. However, the fees can get expensive for certain types of actively managed funds.

What is the downside to an ETF? ›

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

What happens to my ETF if the company fails? ›

An ETF shutting down is not the end of the world. The fund is liquidated and shareholders are paid in cash. It's not fun, though. Often, the ETF will realize capital gains during the liquidation process, which it will pay out to the shareholders of record and that could mean an unnecessary tax burden.

What happens to my ETF if Vanguard fails? ›

Vanguard is paid by the funds to provide administration and other services. If Vanguard ever did go bankrupt, the funds would not be affected and would simply hire another firm to provide these services.

What is the safest ETF to invest in? ›

The S&P 500 ETF comes highly recommended by Warren Buffett, and for good reason. Not only is it safer than many other investments, but it also has a long history of earning positive returns.

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