Why are ETFs more risky than mutual funds?
The short answer is that it depends on the specific ETF or mutual fund in question. In general, ETFs can be more risky than mutual funds because they are traded on stock exchanges. Their value can fluctuate throughout the day in response to market conditions.
Market risk
The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.
While they can be actively or passively managed by fund managers, most ETFs are passive investments pegged to the performance of a particular index. Mutual funds come in both active and indexed varieties, but most are actively managed. Active mutual funds are managed by fund managers.
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
Key Takeaways. ETFs are less risky than individual stocks because they are diversified funds. Their investors also benefit from very low fees.
Both are less risky than investing in individual stocks & bonds. ETFs and mutual funds both come with built-in diversification. One fund could include tens, hundreds, or even thousands of individual stocks or bonds in a single fund. So if 1 stock or bond is doing poorly, there's a chance that another is doing well.
The single biggest risk in ETFs is market risk.
ETFs may close due to lack of investor interest or poor returns. For investors, the easiest way to exit an ETF investment is to sell it on the open market. Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF.
Mutual funds are considered relatively safe investments.
In terms of safety, neither the mutual fund nor the ETF is safer than the other due to its structure. Safety is determined by what the fund itself owns. Stocks are usually riskier than bonds, and corporate bonds come with somewhat more risk than U.S. government bonds.
Why are ETFs better than mutual funds?
Key Takeaways. Many mutual funds are actively managed while most ETFs are passive investments that track the performance of a particular index. ETFs can be more tax-efficient than actively managed funds due to their lower turnover and fewer transactions that produce capital gains.
Limited Capital Gains Tax
As passively managed portfolios, ETFs (and index mutual funds) tend to realize fewer capital gains than actively managed mutual funds. Mutual funds, on the other hand, are required to distribute capital gains to shareholders if the manager sells securities for a profit.
Interest rate changes are the primary culprit when bond exchange-traded funds (ETFs) lose value. As interest rates rise, the prices of existing bonds fall, which impacts the value of the ETFs holding these assets.
ETFs are most often linked to a benchmarking index, meaning that they are often not designed to outperform that index. Investors looking for this type of outperformance (which also, of course, carries added risks) should perhaps look to other opportunities.
The biggest hassle of an ETF closure is it upends your investment timeline, and there's nothing you can do about it. You're forced to sell or take liquidation proceeds, which can create a tax burden or lock in investment losses.
Theoretically, for exotic ETFs, yes — but as a practical matter highly unlikely. And for broad market ETFs that track something like the S&P 500 Index the probability of going to zero is, well, about zero. Every stock in the index would have to go to zero.
Summary. ETFs are not less safe than other types of investments, like stocks or bonds. In many ways, ETFs are actually safer, for instance thanks to their inherent diversification. And by choosing the right mix of ETFs, you can control the market risk to match your needs.
"Leveraged and inverse funds generally aren't meant to be held for longer than a day, and some types of leveraged and inverse ETFs tend to lose the majority of their value over time," Emily says.
Key differences between stocks and ETFs
A single ETF can contain dozens or hundreds of different stocks, or bonds or almost anything else considered an investable asset. Since ETFs are more diversified, they tend to have a lower risk level than stocks.
Holding too many ETFs in your portfolio introduces inefficiencies that in the long term will have a detrimental impact on the risk/reward profile of your portfolio.
What is the safest ETF to invest in?
- Vanguard S&P 500 ETF (VOO 1.12%) ...
- Vanguard High Dividend Yield ETF (VYM 1.03%) ...
- Vanguard Real Estate ETF (VNQ 0.68%) ...
- iShares Core S&P Total U.S. Stock Market ETF (ITOT 1.12%) ...
- Consumer Staples Select Sector SPDR Fund (XLP 1.0%)
There are a few reasons why ETFs generally die. Low assets under management, high fees, poor performance, and short track records are closely associated with the probability of closure. In 2023, there were 244 ETF closures with an average age of 5.4 years and average assets under management of only $54 million.
ETFs. Investment funds are a strategic option during a recession because they have built-in diversification, minimizing volatility compared to individual stocks. However, the fees can get expensive for certain types of actively managed funds.
The license to run a mutual fund house is given after due diligence in a similar way as banks get the banking license. In short, a mutual fund house is as safe as a bank. Mutual funds don't guarantee capital protection or fixed returns.
Inflation is the biggest risk which eats up the returns generated by your investments in mutual funds. If your investments are not generating higher returns than the prevailing inflation rate, then you are just losing money from your investment.
