The Benefits and Risks of ETFs

Like all investments, ETFs present a number of benefit and risks for investors depending on your investment style, knowledge level, risk tolerance, asset mix and time horizon. Here are a few considerations to keep in mind.

Benefits

• Diversification: ETFs are often designed to provide instant diversification. In a single ETF, you could gain exposure to different asset classes, such as equities or fixed income, industry sectors and geographic regions.
• Low fees: Many ETFs are passively managed, which means they tend to have lower management expense ratios (MERs) than actively managed investments.
• Flexibility: Because ETFs trade on a stock exchange, you can buy or sell them during the trading day.
• Transparency: Investors can see the portfolio composition of an ETF in a timely manner since holdings are disclosed daily.
• Portfolio Management: Passive ETFs may generally make fewer trades compared to actively managed ETFs. This may result in lower portfolio turnover, lower management expense ratios and possibly fewer taxable capital gains that must be distributed to investors. 

Risks

When you invest in an ETF, you are exposed to the risks in the underlying securities. Because ETFs can invest in a wide range of asset classes and regions, their risk profiles vary accordingly. Here are a few considerations:

• Underlying asset risk: ETF investors are exposed to any type of risk associated to the underlying basket of investments. For example, a bond ETF is exposed to credit, default and interest rate risks. Look for the risk section of an ETF's prospectus for detailed explanations risks associated with that fund.
• Market risk: The underlying assets of any ETF may fluctuate in value. An ETF that tracks a broad market index such as the S&P 500 is likely to be less volatile than an ETF that tracks a specific industry or sector. The key is to know what the ETF is tracking and understand the underlying risks associated with it.
• Liquidity: Low trading volume doesn't mean low liquidity. An ETF's liquidity is determined by the liquidity of the underlying securities, whereas trading volume is influenced by the activity of investors. The more liquid an ETF, the smaller the bid/ask spread would be. Conversely, ETFs based on less-liquid underlying assets would have wider bid/ask spreads. (Find out more in How to Buy and Sell ETFs.)
• Tracking error: ETFs that track an index should technically deliver about the same returns as the index, but there can be divergence. Tracking error is the difference between the return an investor receives and that of the benchmark the ETF is attempting to replicate. Fees are generally the biggest impact here.
• Pricing differences: The market price of an ETF at any given moment will not always reflect the exact value of the underlying assets. Because ETFs trade on an exchange, investors are exposed to market forces when trading. It is possible that prices could diverge from the net asset value, or NAV.

Remember, there are risks and benefits associated with any investment. It's a good idea to weigh both the risks and benefits when determining if any type of investment is right for you.