Exchange-Traded Funds (ETFs) have exploded in popularity over the past decade, amassing trillions of dollars in assets. They are considered an excellent investment vehicle for all kinds of investors due to their low level of risk and opportunity for diversification.
However, like any investment, they do come with their own set of risks. Analysing ETFs can be complex for many investors, as there is a wealth of options to choose from and a multitude of factors to consider. Before diving into the world of ETFs, investors should understand the potential risks so that they can make informed financial decisions, avoid potential losses and gain the returns they’re hoping for.
ETFs are similar to mutual funds, but they have a few key differences. They both invest in a wide range of securities and provide investors with the opportunity for diversification. Like with mutual funds, investors hold shares in the ETF rather than individual stocks and are entitled to a percentage of the ETF’s total value as a result.
ETFs, however, can be traded like stocks and bonds on the open market – so while mutual fund shareholders make their purchases after the market has closed and the fund’s net asset value has been determined, ETF shareholders can buy and sell shares at any time. This is one of the reasons ETFs are so popular, along with their lower cost, greater transparency, tax-efficiency and inexpensive fees when compared to other types of investments.
ETFs also come in a variety of shapes and sizes, each with its own set of objectives. It is a good idea to understand what the objective of the ETF is before investing.
A Growth ETF for instance will invest in fresh, innovative, rapidly growing companies because the share price of these companies rises quickly. On the contrary, Value ETFs will invest in undervalued companies whose stock prices do not yet reflect their true worth. These are ideal for long-term investors who believe that the company’s stock price will eventually catch up.
Because the vast majority of ETFs are index funds, they are considered relatively safe. An indexed ETF is a fund that invests in the same securities as a particular index – e.g., the S&P 500 – with the aim of matching the index’s annual returns. An index fund naturally includes some risk due to being exposed to the market’s volatility (meaning if the index loses value, the fund will lose value). However, the stock market’s overall trend is bullish, so over time, indexes will increase in value and so will the ETFs that track them.
Are there any downsides associated with ETFs?
All investments come with their own unique set of risks, and ETFs are no exception. It is important to carry out research into your chosen investment vehicle so that you are aware of the risks and refrain from making preventable mistakes.
Lucky for you, arty is here to help. Here are the most common associated risks to have on your radar when you are investing in ETFs.
One of the most appealing features of ETFs is that they trade like stocks. Every time you buy or sell an ETF, you pay a commission, just like you do with stocks. This means trading costs can quickly pile up and hurt the performance of your investment if you trade ETFs too frequently. Due to the stock-like nature of ETFs, you may be tempted by dollar cost averaging (paying in monthly chunks). While this works well for certain types of investing, the main concern with this technique is that you pay your broker a commission each time you want to buy a portion of that ETF. In this regard, no-load mutual funds are more cost-effective than ETFs because they are sold without a commission or sales charge.
ETF trading fees are generally determined by the funds and fund providers themselves. But, as ETFs have continued to grow in popularity, so has the number of commission-free funds. Many providers, including Vanguard, are allowing clients to buy and sell ETFs without paying a commission.
To avoid repeatedly paying commission fees when trading ETFs, use the lump sum technique. As its name suggests, a lump sum payment involves depositing a large amount of money into your investment all at once. So, if you had €1000 to invest, you’d invest all of it into the ETF in one go.
For example: The net investment on a €1,000 investment with €10 trading fees is €990, meaning that the percentage of your money that is lost due to trading costs is only 1%. If you were to invest €25 and the same trading fees apply, the percentage of your investment that you lose as a result of trading costs is 40%.
When it comes to ETF trading, bigger lump sums result in lower commission fees. Unless you invest substantial sums on a regular basis, brokerage costs may outweigh the benefits of dollar-cost averaging.
Capital Gains Tax
Not understanding the tax implications of an ETF that you invest in can lead to dissatisfaction with your earnings. Capital Gains Tax is a tax on the profit you make when you sell something you own. It’s calculated based on the profit made – i.e., the increase in value between the sale price and purchase price – for an asset owned for more than a year.
An ETF may distribute capital gains to shareholders in some instances. This is not always ideal for ETF holders, as the responsibility to pay the capital gains tax falls on them. Rather than distributing capital gains and creating a tax burden for the investor, funds should keep them and re-invest them, but this doesn’t always happen.
As different ETFs handle capital gains distributions differently, it can be difficult for investors to keep track of the funds they own and taxes they owe. Before investing in an ETF, it’s critical to understand how the fund handles capital gains distributions.
Liquidity is the most important component in any ETF, stock, or other publicly traded asset. When you buy anything, liquidity means that there is enough trading interest that you can get out of it relatively fast without altering the price.
ETFs tend to have greater liquidity when compared to other investments like mutual funds. An ETF’s liquidity depends on a combination of factors, including: The ETF’s composition, the trading volume of the individual assets that the ETF is comprised of, the trading volume of the ETF itself and the overall investment environment.
An ETF that is thinly traded can be a difficult investment to get out of. You can usually tell if an investment is illiquid if there is a large spread between the bid and ask. Before buying an ETF, make sure it’s liquid. The easiest way to accomplish this is to look at the spreads and market fluctuations over the course of a week or month.
ETFs are praised for the diversification they provide to investors. It’s crucial to remember, though, that just because an ETF has multiple underlying positions doesn’t imply it won’t be influenced by volatility. The possibility for large swings is largely dependent on the fund’s scope. If an ETF tracks a broad market index, like the S&P 500, it will likely face less volatility than an ETF that tracks a specific industry, such as oil.
As a result, it’s critical to understand the fund’s goals as well as the types of investments it holds. This has become even more of an issue as ETFs have become more specific in tandem with the industry’s growing popularity.
Importantly, where international or global ETFs are concerned, several elements must be considered when determining the viability of an ETF. It is critical to take into consideration the fundamentals of the country that the ETF is tracking, as well as the creditworthiness of that country’s currency. The performance of any ETF that invests in a specific country or region will also be heavily influenced by economic and social volatility.
As a golden rule, always know exactly what the ETF is tracking. Don’t be fooled into thinking that just because some ETFs have minimal volatility, that they’re all the same.
We know that many investors opt for ETFs because they are generally less risky than other vehicles of investment.
Although most ETFs are indexed, a new type of ETF investment has emerged. Leveraged ETFs monitor indexes, but instead of merely investing in the indexed assets and allowing the market do its job, these funds use a large amount of debt to try and outperform the indexes. Leverage is the term used to describe the use of debt to raise the profits, which is how these products got their name.
Leveraged ETFs borrow a certain amount of money and use it to raise the amount of their investment. While this appears to be a good deal, the value of a leveraged ETF can be highly volatile because the underlying index’s value is continually changing. If the index plummets, the fund’s value could hit rock bottom as well.
These ETFs also tend to lose value over time as a result of daily resets. Even if the underlying index is performing well, this can still happen. For this reason, specialists advise against investing in leveraged ETFs, but those investors who do choose to use this technique should keep a careful eye on their investments and fully weigh the risks and rewards.
In conclusion: Are ETFs safe to invest in?
When used correctly, ETFs are considered to be a safe investment overall. Like any other financial product, certain ETFs are riskier than others, but these risks can be avoided easily – provided you do your research before investing. You should always seek to understand the underlying goal of the ETF, and determine whether it will provide safe, regular returns instead of risking your life savings.
The major issues with ETF investing come down to the investor’s level of knowledge, sneaky fees, and liquidity. Safely buy ETFs by choosing solid, low-cost ETFs, such as the S&P 500 index fund. Favour a lump sum approach when you can as this will save you on commission fees, and be wary of ETFs with large spreads between the bid and ask prices.
When it comes to buying specific stocks or ETFs, knowledge is your most valuable asset. The majority of investor issues can be solved simply by knowing what you’re investing in. Make sure you have researched your investments and, if you’re hesitant, you can always refer to an investment specialist. Don’t put your money into anything you don’t understand.
Lastly, if you are ever unsure about any investments or want to learn more about accumulating long-term wealth, seek professional advice. Another option would be to use a Robo-advisor. Robo-advisors like arty are a great option if you want to reduce the complexity of the investment process, protect and grow your money for the future, and decrease the high costs commonly associated with wealth management. Whether it’s an AI-backed Robo-advisor or a human advisor you’re looking for, seeking help to optimize your portfolio can be a game-changer.
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