Five risks to know when investing in ETFs

Exchange-traded funds (ETFs) are a favorite tool of many financial professionals and individual investors who like their competitive fees, tax efficiency, transparency, and ease of use.

That’s why the ETF industry has grown significantly, finishing 2023 with more than $8 trillion in assets under management, a new annual milestone.¹ Invesco QQQ was one of the first ETFs on the scene in 1999.

Like any investment, though, it’s important to be fully aware of the potential risks involved. In this article, we’ll outline five key risks investors should consider before investing in ETFs:

1. Market risk
2. Tracking error
3. Liquidity
4. Sector concentration
5. Single-stock concentration

Risk 1: Market risk

Although QQQ and other ETFs have helped democratize investing, the benefits of the ETF structure don’t remove any of the inherent risks of investing in stocks, bonds, real estate, and other asset classes.

The Nasdaq-100 Index, which QQQ tracks and provides exposure to some of the world’s most innovative companies, has a cumulative total return of 726% since 2008.² QQQ has also delivered solid performance over the years, returning 17.65% over the past 10 years and outpacing the S&P 500 by 5.88% in the same time frame, but it is important to keep in mind that the Nasdaq-100 has posted six annual losses since launching in 1985. In 2008, the Nasdaq-100 fell more than 40% as stocks suffered during the financial crisis.³

Standardized performance – Fund performance shown at NAV. Performance data quoted represents past performance, which is not a guarantee of future results; current performance may be higher or lower than performance quoted. Investment returns, and principal value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. An investor cannot invest directly in an index. Index returns do not represent Fund returns. Invesco QQQ's total expense ratio is 0.20%

It's a good reminder that losses are an inevitable part of investing. That’s why keeping a long-term mindset can help investors stay disciplined during times of volatility.

Risk 2: Tracking error

Tracking error is the risk that the performance of an ETF falls short of the index to which it’s tied and may be caused by many reasons. Tracking error is relevant for index-based ETFs only; it’s typically not an issue for actively managed ETFs. The U.S. ETF market is mostly in passive strategies with active ETFs accounting for only 6.5% of assets.

There are several factors that can create index tracking error in an ETF, including:

• The skill and experience of the portfolio manager
• Taxes and capital gains distributions (which some indexes don’t have to pay)
• Whether the ETF fully replicates or uses a representative sample of the index
• ETF fees and commissions (which reduce what investors get to keep)
• The ETF’s trading costs
• Performance differential from cash

Over the past decade, Invesco QQQ has closely tracked the Nasdaq-100 when fees are taken into consideration. For the last 10 calendar years ended 2023, QQQ has an annualized NAV return of 17.65%, compared with 17.89% for the Nasdaq-100.⁴

Risk 3: Liquidity

The liquidity of an investment is defined by how easy it is to buy and sell without significantly impacting its price.

When it comes to ETFs, there are three sources of liquidity:

• Secondary market (on-screen) liquidity: Investors trading ETF shares on exchanges; reflected in the quoted trading volume and bid/ask spreads of an ETF 
• Primary market liquidity: The ability of authorized participants (APs) to create and redeem large blocks of ETF shares in response to supply and demand in the market
• Liquidity of underlying asset class: The liquidity of an ETF is also impacted by how liquid the securities are in which it invests (i.e., U.S. large-cap stocks are more liquid than emerging market bonds)

As the second most traded ETF based on average daily volume traded within the U.S., QQQ has long been considered one of the most liquid ETFs available to investors as of December 31, 2023.⁵ Also, in terms of its underlying portfolio, the stocks in the Nasdaq-100 are also highly liquid and the popular benchmark has futures and options contracts based on it, which can further boost liquidity.⁶

Risk 4: Sector concentration

When considering purchasing an ETF, it’s a good idea to go beyond the fund’s name to understand the holdings in its portfolio. Most ETFs disclose their entire portfolio on a daily basis. Although an ETF may appear diversified, it can have tilts to certain sectors that can significantly impact its performance.

Dividend ETFs, which some equity investors use for income, may provide an illustration. These ETFs’ portfolios may be focused in sectors like utilities, financials, and consumer staples because historically those industries have tended to have high dividend yields. Bottom line: Don’t judge a book by its cover and make sure you understand exactly what you’re getting when you buy an ETF.

Risk 5: Single-stock concentration

Investors may also want to check to see if an ETF has outsized positions in particular stocks. When researching ETFs and their tracking indexes, some online tools and websites let investors check the percentage of the portfolio in the 10 largest holdings, as an example.

Single-stock concentration has become a hot-button issue because some of the largest technology stocks, the so-called Magnificent 7, have gotten so big that they’ve started to dominate some benchmarks that weight stocks by market capitalization. That means a relatively small handful of stocks can have an outsized impact on an index’s performance.

This risk is also an important one to consider when investing in sector-focused ETFs that track market-capitalization-weighted benchmarks. For instance, the S&P Technology Select Sector Index has more than 43% combined in just two stocks: Microsoft and Apple.⁷

While the Nasdaq-100 is made up of 101 holdings, Invesco QQQ’s top 10 holdings had combined weight of 45.46% as of December 31, 2023. Apple and Microsoft, the 2 largest holdings in QQQ, make up 17.83% of the ETF.⁸

Key takeaways

• ETFs have some structural advantages relative to mutual funds but it’s important to remember that ETFs have risks like all investments.
• Five of the key ETF risks to consider include: market risk, tracking error, liquidity, sector concentration, and single-stock concentration.
• A little due diligence can go a long way before purchasing an ETF, so don’t judge a book by its cover.