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)

FAQs

ETFs Can Be Safe Investments If Used Correctly? ›

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.

Are ETFs a safe way to invest? ›

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.

Can ETFs be risky? ›

The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment.

Why are ETFs more safe? ›

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 guaranteed? ›

ETFs do not provide any guarantees of future performance. As with any investment, you might not get back the money you invested. An ETF's risk rating can change over time.

What happens if an ETF fails? ›

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. Receiving an ETF payout can be a taxable event.

Are ETFs as safe as index funds? ›

Neither an ETF nor an index fund is safer than the other because it depends on what the fund owns. 45 Stocks will always be riskier than bonds but will usually yield higher returns on investment.

What is the biggest risk in ETF? ›

The single biggest risk in ETFs is market risk.

Why is ETF not a good investment? ›

Buying high and selling low

At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. Those are not good times to transact business.

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 downside of an ETF? ›

Disadvantages of ETFs. Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ETFs are traded on the stock exchange like an individual stock, which means that investors may have to pay a real or virtual broker in order to facilitate the trade.

What is the safest investment with the highest return? ›

Here are the best low-risk investments in April 2024:
  • High-yield savings accounts.
  • Money market funds.
  • Short-term certificates of deposit.
  • Series I savings bonds.
  • Treasury bills, notes, bonds and TIPS.
  • Corporate bonds.
  • Dividend-paying stocks.
  • Preferred stocks.
Apr 1, 2024

Is ETF 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 become worthless? ›

In fact, 47% of all such funds have closed down, compared with a closure rate of 28% for nonleveraged, noninverse ETFs. "Leveraged and inverse funds generally aren't meant to be held for longer than a day, and some types of leveraged and inverse ETFs tend to lose the majority of their value over time," Emily says.

What happens to my ETF if Vanguard fails? ›

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

Do ETFs pass through losses? ›

Currency ETFs do not generate capital gains or losses, but rather ordinary income or losses. This means that losses on the sale of shares in these ETFs produce ordinary losses that can be used to offset ordinary income, such as wages and bank interest.

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.

Is it smart to just invest in ETFs? ›

ETFs make a great pick for many investors who are starting out as well as for those who simply don't want to do all the legwork required to own individual stocks. Though it's possible to find the big winners among individual stocks, you have strong odds of doing well consistently with ETFs.

What is the safest ETF to buy? ›

Funds 1-5
  1. Vanguard S&P 500 ETF (VOO -0.07%) ...
  2. Vanguard High Dividend Yield ETF (VYM 0.24%) ...
  3. Vanguard Real Estate ETF (VNQ 0.19%) ...
  4. iShares Core S&P Total U.S. Stock Market ETF (ITOT 0.06%) ...
  5. Consumer Staples Select Sector SPDR Fund (XLP 0.76%)

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