It can be very easy to get carried away by the hype about the quality of exchange-traded funds (ETFs). Yet they still carry many of the same risks as stocks and mutual funds, as well as some risks unique to ETFs. Here’s a look at the “fine print” for ETFs.

Tax risk

Tax efficiency is one of the most promoted benefits of an ETF. While some ETFs, such as a US equity index ETF, offer great tax efficiency, many other types do not. In fact, not understanding the tax implications of an ETF you’re investing in can come as a nasty surprise in the form of a bigger-than-expected tax bill.

ETFs create tax efficiency by using in-kind exchanges with authorized participants (AP). Instead of the fund manager needing to sell shares to cover redemptions as they do in a mutual fund, the manager of an ETF uses an exchange of one ETF unit for the actual shares of the fund. This creates a scenario where capital gains on the shares are actually paid by the AP and not by the fund. Thus, you will not receive any capital gains distributions at the end of the year.

However, once you move away from index ETFs, other tax issues can potentially arise. For example, actively managed ETFs may not make all of their sales through an in-kind exchange. They may in fact realize capital gains which should then be distributed to fund holders.

Tax exposures to different types of ETFs

If the ETF is an international type, it may not have the capacity to trade in kind. Some countries do not allow redemption in kind, which creates capital gain issues.

If the ETF uses derivatives to achieve its objective, then there will be capital gains distributions. You cannot make in-kind trades for these types of instruments, so they must be bought and sold in the regular market. Funds that typically use derivatives are leveraged funds and inverse funds.

Finally, commodity ETFs have very different tax implications depending on the structure of the fund. There are three types of fund structures and they include: grantor trusts, limited partnerships (LPs), and exchange-traded notes (ETNs). Each of these structures has different tax rules. For example, if you are part of a grantor trust for a precious metal, you are taxed as if it were a collector’s item.

The point to remember is that ETF investors should pay attention to what the ETF invests in, where those investments are located, and how the actual fund is structured. If you are unsure of the tax implications, consult your tax advisor.

Business risks

One of the best things about investing in an ETF is that you can buy it like a stock. However, it also creates many risks that can hurt your return on investment.

First, it can change your mindset from an investor to an active trader. Once you start trying to time the market or pick the next hot sector, it’s easy to get caught up in regular trading. Regular trading adds costs to your portfolio, eliminating one of the benefits of ETFs, low fees.

In addition, it is very difficult to achieve regular trades to try to time the market. Even paid fund managers struggle to do so every year, with most not beating the indices. While you could make money, you’d be better off sticking with an index ETF and not trading it.

Finally, by adding to these negative trading excesses, you expose yourself to more liquidity risk. Not all ETFs have a large asset base or high trading volume. If you are in a fund that has a wide bid-ask spread and low volume, you may have problems closing your position. This pricing inefficiency could cost you even more money and even suffer greater losses if you cannot exit the fund in a timely manner.

Portfolio risk

ETFs are often used to diversify passive portfolio strategies, but this is not always the case. There are many types of risk associated with any portfolio, from market risk to political risk to commercial risk. With the wide availability of specialist ETFs, it is easy to increase your risk in all areas and thus increase the overall risk of your portfolio.

Every time you add a fund for a single country, you add political and liquidity risk. If you buy a leveraged ETF, you magnify how much you will lose if the investment goes down. You can also quickly spoil your asset allocation with each additional trade you make, increasing your overall market risk.

Being able to trade ETFs with so many niche offerings, it can be easy to forget to take the time to make sure you’re not making your portfolio too risky. Finding out would happen when the market goes down and you can’t do much about it.

tracking error

Although rarely considered by the average investor, tracking errors can have an unexpectedly large effect on an investor’s returns. It is important to research this aspect of any ETF index fund before investing.

The objective of an ETF index fund is to track a specific market index, often referred to as the fund’s target index. The difference between the returns of the index fund and the target index is known as a fund’s tracking error.

Most of the time, the tracking error of an index fund is small, perhaps only a few tenths of a percent. However, various factors can sometimes combine to create a difference of several percentage points between the index fund and its target index. In order to avoid such a nasty surprise, index investors need to understand how these spreads can develop.

Lack of price discovery

Some analysts fear that one of the risks looming on the horizon is a situation in which a large majority of investments shift to passive indexed investments using ETFs. If a preponderance of investors own ETFs and do not trade the individual stocks therein, price discovery of the individual securities that make up the index may be less effective. In the worst case, if Everybody only owns ETFs, there is no one left to set the price of the stocks that make them up and, therefore, market breakouts.

The essential

ETFs have become so popular because of the many benefits they offer. Nevertheless, investors should keep in mind that they are not without risk. Know the risks and plan around them, then you can reap the full benefits of an ETF.