ETFs offer diversification benefit at a low cost. In spite of these benefits, one should make note of the risks that are involved with such investments. Firstly, there are many kinds of ETFs available in the market including international and exotic ones. Hence selecting the right ETF to meet your need is the key to avoiding additional risks like political risk and liquidity risk that may be associated with these ETFs. ETFs can also be exposed to counterparty risk and currency risk depending on their underlying holdings.
ETFs can have different structures depending on what they invest in and how they distribute the capital gains from the portfolio. This can affect the tax liability for the investor. For instance, ETFs using in-kind exchanges do not distribute capital gains to end investors while ETFs involving derivatives or commodities may have complex structures and tax implications. Unless an investor is aware of these things, he may be caught off-guard.
ETFs are exposed to market risk like stocks and other Mutual Funds in spite of their diversification benefits. The broader the index an ETF tracks, the lesser will be its market risk but it can’t be completely eliminated. ETFs face tracking error i.e. their return will deviate from the return of the underlying index because an ETF incurs certain expenses that the index doesn’t face.
