The risks of investing in ETFs

1. Market risk: This is the risk that an ETF's value will decrease due to market fluctuations. The maximum loss a client can face when investing in an ETF depends on the amount invested and the performance of the ETF. If all the fund’s holdings go to 0, it is possible to lose the entire invested amount. However, as most ETFs are diversified, this scenario is typically unlikely. 
   
   
2. Liquidity risk: Imagine you want to sell your old car, but there aren’t many buyers. You might have to lower your price or wait a while to find a buyer. This scenario illustrates liquidity risk and it can also affect certain ETFs that hold assets that are harder to sell, such as small cap securities or exotic investments. The difference between the buying and selling price of an asset is known as the spread, and it is typically larger for illiquid assets compared to liquid ones.
   
   
3. Tracking error: ETFs are designed to replicate the performance of specific indices. However, for various reasons, their performance can sometimes diverge significantly from the index they track. This difference is known as tracking error. A lower tracking error is preferable as it indicates that the ETF is effectively tracking the index without taking on additional active risk.
   
   
4. Concentration risk: Certain ETFs, particularly thematic ETFs only invest in specific themes, trends, sectors or industries. This concentration can increase the risk of potential losses due to overexposure to a single theme or sector. If that sector underperforms, your investment could be more adversely affected than a more diversified ETF.
   
   
5. Counterparty risk: Some ETFs, most particularly leveraged and inverse ETFs invest in complex assets like derivatives. With derivatives, one party is exposed to the risk that the other party in the trade defaults which could have a negative impact on the performance of the ETF.
   
   
6. Tax risk: Although ETFs are generally more tax efficient than mutual funds, active ETFs and ETFs that invest in international markets may incur capital gains distributions, resulting in unexpected tax liabilities. It is crucial to review an ETF key information document or prospectus to gain a better understanding of how the fund is managed and the type of investment the fund holds.
   
   
7. Currency risk: This is the risk that affects an ETF that invests in foreign assets. For instance, consider a French-based ETF that invests in an American company like Apple. If the USD depreciates relative to the Euro, the value of the Apple position decreases, negatively impacting the ETF's  performance.
   
   
8. Leverage risk: Certain ETFs use leverage, (i.e., borrowed money) to control larger positions than they could otherwise manage. Leverage allows a fund to amplify its returns, but it also magnify losses. The greater the leverage, the higher the risk.

Depending on the specific type of ETF, there may be additional risks such as interest rate risk, credit risk, or geopolitical risk. It’s essential to review an ETF's documents to thoroughly understand the specific risks associated with the ETF.

If you are ready to invest in ETFs, check out our fourth and final chapter to find out what to look for when choosing ETFs.