It can be really easy to get caught up in the hype about exchange-traded funds (ETFs). But investors should keep in mind that they come with many of the same risks as stocks and mutual 🔴funds, plus some risks that are unique to some ETFs.

Tax Risks of ETFs

Tax efficiency is one of the most promoted advantages of an ETF. But not all ETFs can boast this efficiency. The tax risk depends on how actively the ETF is managed. Not understanding the tax implications can add up to a nasty surprise in the form of a bigger-than-ꦿexpected tax bill.

ETFs create tax efficiency by using in-kind exchanges with 澳洲幸运5官方开奖结果体彩网:authorized participants (AP). This is different from how traditional mutual funds are managed. A mutual fund m꧅anager must sell stocks to cover redemptions. The manager of an ETF uses an exchange of an ETF unit for the actual stocks within the fund.

That means capital gains on the stocks are actually paid by the AP and not the ETF. You will not receive 澳洲幸运5官方开奖结果体彩网:capital gains distributions at the end of the year.

However, once you move away from index ETFs there are more taxation issues. 澳洲幸运5官方开奖结果体彩网:Actively managed ETFs may not do all of their selling♊ via an in-kind e♌xchange. They can actually incur capital gains, which would then need to be distributed to the fund holders.

ETFs that Have Tax Exposure

There are seve🔜ral broad types of ETFs that can produce capital gains distribtions. They include international ETFs and ETFs that u𓆉se derivatives or invest in commodities

An international ETF may not have the ability to do in-kind exchan💜ges. Some 🅺countries do not allow for in-kind redemption, thus creating capital gain issues.

If the ETF uses 澳洲幸运5官方开奖结果体彩网:derivatives to accomplish their objective, there will be capital gains distributions. You cannot do in-kind exchanges for these types of instruments, so they must be bought and sold on the regular market. Funds that typically use derivatives are 澳洲幸运5官方开奖结果体彩网:leveraged funds and 澳洲幸运5官方开奖结果体彩网:inverse funds.

Finally, 澳洲幸运5官方开奖结果体彩网:commodity ETFs have very different tax implications depending on how the fund is structured. There are three types of fund structures and they include 澳洲幸运5官方开奖结果体彩网:grantor trusts, 澳洲幸运5官方开奖结果体彩网:limited partnerships (LP) and 澳洲幸运5官方开奖结果体彩网:exchange-traded notes (ETNs). Each of these structures have different tax rules. For example, if you are in a grantor trust for a precious metal you are taxed as if it were a 澳洲幸运5官方开奖结果体彩网:collectible.

The takeaway is that ETF investors need to pay attention to what the ETF is investing in, where those investments are located and how the actual fund is structured. If you have doubts on 澳洲幸运5官方开奖结果体彩网:the tax implications check with a tax advisor before investing.

Trading Risks

One of the advantages of investing in ETFs ไis that they can be bought and 🌸sold like stocks. This also creates risks that can hurt your investment return.

First, it can change your mindset from investor to active trader. Once you start trying to 澳洲幸运5官方开奖结果体彩网:time the market or pick the next hot sector it is easy to get caught up in regular trading. Regular trading adds cost to your portfolio, thus eliminating one of the benefits of ETFs, their low 🐻fees.

In any case, regular trading to try and time the market is really hard to do successfully. Even paid fund managers struggle to do this every year, with few beating the indexes. You would be better off sticking with an index ETF and not trading it.

Portfolio Risks

There are many types of risk that come with any portfolio, from 澳洲幸运5官方开奖结果体彩网:market risk to 澳洲幸运5官方开奖结果体彩网:political risk to 澳洲幸运5官方开奖结果体彩网:business risk. With the wide availability of specialty ETFs it's easy to increase your risk across all areas ꦫand thus increase the overall riskiness of your portfolio.

Every time you add a single country fund you add political and liquidity risk. If you buy into a leveraged ETF you are amplifying ❀how much you can lose if the invest🍬ment crashes. You can also easily mess up your asset allocation with each additional trade that you make, thus increasing your overall market risk.

The ability to trade in and out of ETFs with many niche offerings makes it easy to lose sight of the balance and diversity that you need to protect your portfolio. You don't want to discover that after your portfolio suffers steep losses.

Tracking Error

Although rarely considered by the average investor, 澳洲幸运5官方开奖结果体彩网:tracking errors can have an unexpected material effect on an investor's returns. It is important to inve🍬stigate this aspect of any ETF index fund before investing.

The goal of an ETF 澳洲幸运5官方开奖结果体彩网: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 the fund's tracking error.

Most of the time, the tracking error of an index fu𝔍nd is small, perhaps a few tenths of one percent. However, a variety of factors can conspire to open a gap of several percentage points between the index fund and its target index.

Checking a fund's tracking error over time can at least assure you of its historical performance.

Liquidity Risk

Not all ETFs have a large asset base or high trading volume. If you find yourself in a fund that has a large 澳洲幸运5官方开奖结果体彩网:bid-ask spread an🐭d low volume you could run into problems with selling your shares. That pricing inefficiency could cost you more money and greater losses.

The꧟ other angle here is the inability to get out of a position quickly. A lack of liqu💖idity can delay execution of a trade. This can be a critical error for those looking to exploit arbitrage opportunities or time their exit to a narrow window.

Concentration Risk

Many ETFs hone in on specific sectors, industr💯ies, or asset classes. This focus ties the ETF to the fortunes of that particular sector, for better or for worse.

Such ETFs lack some of the diversification that is one of the great benefits of E𝓰TFs and mutual f𓂃unds.

Sector-specific economic and cyclical factors, combined with market and regulatory changes, add to the risk. Consider the cyclical flows in real estate. ▨A real estate ETF may hol♔d many assets, but as a whole their performance is dependent upon one industry.

Investors can reduce this risk by 澳洲幸运5官方开奖结果体彩网:diversifying their portfolios across various sectors and asset classes. You caℱn do this by investing in a mix of ETFs that include broad-market and multi-sector choices.

A good understanding of your risk tolerance is key when dealing with sector-specific ETFs. Make sure they're in line with your 澳洲幸运5官方开奖结果体彩网:investment goals and risk comfort level🐠, an⛎d evaluate how you'd feel if an entire industry were to collectively hit the skids.

Lack of Price Discovery

The increasing popularity of ETFs has s🐬ome analysts worried.

If a preponderance of investors do not trade individual stocks but invest in index ETFs, price discovery for the s🌞tocks constitute and index may become less efficient.

In the worst case, if everybody owns just ETFs, then nobody is left to pꦜrice the component stocks and thus the mܫarket breaks.

The Bottom Line

ETFs have become popular because of their many advantages, Still, investors must keep in mind that they aren't without risks. Know the risks and plan around them then you can take full advantage of the benefits.