10 Biggest Risks With ETFs

Market Risk
As baskets of securities, passively managed ETFs can't avoid the fates of the markets they track—nor should they. That's the whole point. Still, if a market plummets, so too will the ETF tracking it. No matter how great your ETF is, it can't protect you from that.

Composition Risk
Indexes—and the ETFs that track them—aren't interchangeable. Two ETFs may track the same space, but one may outperform, while the other underperforms. Why? Composition: One fund's particular lineup of securities and weightings offers better returns than the other.

So know what you own. Acquaint yourself with an ETF's holdings and their weights before you buy.

Methodology Risk
Many ETFs slice and dice the market in creative, yet nonintuitive ways. Yes, the U.S. Oil ETF (USO | B-100) is an oil fund, but it doesn't track the price of crude. TheProShares Ultra QQQ ETF (QLD) may be a 2x leveraged ETF, but it won't return 200 percent of its benchmark's annual returns.

If you don't understand how an ETF accomplishes what it promises to do, it's best to stay clear.

Task Risk
Though most ETFs are tax efficient, not all are. Take the SPDR Gold Trust (GLD | A-100). Even though GLD trades like a stock, the IRS still taxes you based on what the ETF holds: gold bullion— meaning you pay the 28 percent "collectibles" tax, no matter how long you hold GLD.

Read up on a fund's tax treatment, especially for commodity and currency ETFs, which tend to be taxed differently than other funds.

Counterparty Risk
Generally, ETF securities-lending programs are pretty safe. But with ETNs, counterparty risk can come into play. That's because ETNs are unsecured debt notes issued by a bank; if that bank goes out of business, you're out of luck. Think it won't happen? So did the investors left out to dry in 2008, when Lehman Brothers imploded and suddenly had to shutter its ETNs.

That's not to say you shouldn't own ETNs—just be prepared, in case.

Closure Risk
Every year, about 100 ETFs close. When this happens, managers liquidate the fund and pay their shareholders in cash, meaning they can often realize capital gains in the process. Transaction costs can rack up too. One fund even stuck shareholders with legal expenses.

To avoid paying through the nose, we recommend you sell out of an ETF as soon as it announces its closing.

Hype Risk
With so many new funds launching every day, buzz is inevitable. But be wary of chasing the newest hotness. Study an ETF's documentation and methodology closely, and don't trust backtested returns. Remember: There's no such thing as a free lunch.

Crowded Trade Risk
ETFs have opened up underexplored areas of the market to new investors, such as bank loans or frontier markets. But as money rushes in, the allure of these assets can diminish. Illiquid markets can also be moved by too large an influx of cash. So invest smart. If the asset wasn't a core part of your portfolio a year ago, then it probably shouldn't be now.

Trading Risk
Like stocks, ETFs have trading spreads, which vary from pennies to dollars. That spread can change over time, as well as for the amount of shares you want to trade. Since these costs can quickly erode returns, research an ETF's liquidity before you buy, and always, always trade with limit orders.

'Catastrophe' Risk
Most ETFs work like they're supposed to, closely tracking their indexes and trading near NAV. But sometimes things go wrong: Markets suffer political or economic turmoil, and ETF prices go out of whack. This especially happens to ETNs or commodity ETFs when, for various reasons, a product stops issuing new shares; these funds consequently develop sharp premiums.

Buying at a premium usually means you'll lose money when you sell. So be wary of high premiums or discounts—they're often a sign something's gone wrong.