The risks of ETF investing and how to manage them

Key takeaways:

• ETF investing can offer diversification and flexibility, but ETFs still carry risks and can fall in value when the underlying market declines.
• Market risk is unavoidable for ETFs, although diversification across asset classes, sectors and time horizons may help manage portfolio volatility.
• Liquidity risk can increase trading costs during stressed markets, especially for niche ETFs, so trading volume, spreads and limit orders are important considerations.
• Tracking error can cause an ETF’s returns to differ from its benchmark, with fees, replication methods, cash drag and derivatives all playing a role.
• Counterparty and concentration risk depend on an ETF's structure and holdings, making it important to review synthetic exposure, securities lending, top holdings, and fund weightings.

While ETFs can offer advantages, they still carry risks. Understanding these risks can help you compare products and assess whether a fund fits your objectives. So let’s look at the main risks associated with ETF investing, as well as practical ways investors may manage them.

Market risk: The unavoidable reality

Market risk—the possibility that the entire market will decline—affects all investments, including ETFs. When the underlying market falls, an ETF tracking that market will typically fall too (though outcomes can differ due to tracking differences, fees, and structure).

Mitigation strategies:
- Diversify across different asset classes (equities, bonds, commodities).
- Consider allocating to sectors that are sometimes viewed as more defensive (such as consumer staples or utilities), noting they can still fall and may carry sector-specific risks.
- Maintain a long-term perspective through market cycles.
- Some investors with lower risk tolerance use bond ETFs to seek lower portfolio volatility, while recognising that bond ETFs can still fall in value.

Illustrative example:
During a market downturn, a globally diversified portfolio with 60% equity ETFs and 40% bond ETFs may have experienced less volatility than an all-equity portfolio, but outcomes vary by holdings, rebalancing, and market conditions.

Liquidity risk: When trading becomes difficult

Liquidity risk refers to the potential difficulty of buying or selling an ETF at a fair price, particularly during market stress. Some ETFs, especially those tracking niche markets or less liquid assets, may experience wider bid-ask spreads during volatile periods.

Mitigation strategies:
- Focus on ETFs with higher average daily trading volumes (for example, higher volumes can help, but there is no single threshold that guarantees liquidity).
- Check the ETF's assets under management, while recognising that liquidity also depends on the underlying holdings, market-maker activity and market conditions.
- Use limit orders rather than market orders when trading.
- Some investors prefer to avoid trading during the first and last 30 minutes of the trading day, when spreads can be wider, but conditions vary by market and ETF.

Illustrative example:
During market turbulence, a thinly traded frontier-market ETF might see its bid-ask spread widen materially, increasing trading costs. In contrast, a major S&P 500 ETF often has tighter spreads than a niche ETF, although spreads can still widen during periods of market stress.

Tracking error: When performance deviates

Tracking error is a measure of how much an ETF’s returns vary relative to its benchmark over time. Higher tracking error indicates greater variability versus the index (which can arise from fees, sampling, rebalancing, cash drag, securities lending, and—where used—derivatives).

Mitigation strategies:
- Review the ETF's historical tracking error before investing.
- Compare replication methods, as physical and synthetic ETFs can have different tracking, collateral, counterparty and cost characteristics.
- Consider physically-replicated ETFs for major markets, which often have lower tracking error than synthetic alternatives.
- Be particularly vigilant about tracking error in less liquid markets.

Real-world example:
Two ETFs tracking the same European equity index might have tracking errors of 0.1% and 0.4% respectively. Over a long period, these differences could contribute to noticeable performance differences, but the relationship is not mechanical and depends on return patterns as well as costs and replication method.

Counterparty risk: The third-party factor

Counterparty risk is mainly associated with synthetic ETFs, which use swap agreements with financial institutions to replicate index performance rather than directly holding the underlying assets. Physical ETFs can also have counterparty risk where securities lending is used.

Mitigation strategies:
- Compare whether physical or synthetic replication is more appropriate for the role the ETF plays in the portfolio.
- If using synthetic ETFs, review the collateral policy, swap structure and counterparty information where disclosed.
- Consider whether any synthetic ETF exposure is appropriate given the portfolio’s objectives, risk tolerance and existing exposures.

Example:
During periods of financial stress, investors may pay closer attention to swap counterparties, collateral quality and ETF structure.

Concentration risk: Too many eggs in one basket

Some ETFs, particularly sector or thematic ETFs, may have high concentrations in a small number of companies, potentially increasing volatility and risk.

Mitigation strategies:
- Check the ETF's top holdings and their weightings before investing.
- Pay close attention to ETFs where the top 10 holdings represent a large share of the fund, as this can increase concentration risk.
- Balance concentrated ETFs with broader market exposure.
- Consider equal-weighted ETFs for sectors where you want to reduce single-stock concentration.

Illustrative example:
A technology sector ETF might have over 40% of its assets in just five large tech companies. If these companies underperform, the ETF could underperform the broader market significantly.

In Conclusion

Understanding these risks could help you compare ETF structures, assess whether a fund fits your objectives and manage portfolio exposure more deliberately. Always remember that ETFs can still fall in value, and risk-management steps do not guarantee positive returns or prevent losses.