--- title: "ETF Investing Risks: Tracking Error, Liquidity, Concentration and More" description: Learn the key risks of ETF investing, including market risk, tracking error, liquidity, concentration, costs, counterparty exposure and fund closure. image: https://blog.palance.co/hubfs/photo-1648098893250-1d03dce92467.jpeg --- [Skip to main content](https://blog.palance.co/investing-in-etfs-understanding-the-risks-for-investors#main) [![palance\_primarylockup\_reverse](https://blog.palance.co/hs-fs/hubfs/palance_primarylockup_reverse.png?width=150&height=50&name=palance_primarylockup_reverse.png) ![palance\_primarylockup\_reverse](https://blog.palance.co/hubfs/palance_primarylockup_reverse.svg)](https://www.palance.co) Open main navigation Close main navigation - Search - [Get Started](https://palance.co/) [Blogs](https://blog.palance.co) [Get Started](https://palance.co/) [Blogs](https://blog.palance.co) Search # ETF Investing Risks: Tracking Error, Liquidity, Concentration and More # ETF Investing Risks: Tracking Error, Liquidity, Concentration and More ![Palance](https://blog.palance.co/hs-fs/hubfs/palance_icononly.png?width=50&height=50&name=palance_icononly.png) by [Palance](https://blog.palance.co/author/palance) Aug 25, 2023, 3:11:11 PM Exchange-traded funds can make diversification and market access easier, but an ETF is not automatically a low-risk investment. The risks depend on what the fund owns, how it tracks its benchmark, how liquid the underlying assets are and how the product is structured. Investors should therefore assess the ETF itself and the exposures it creates inside the wider portfolio. ## What Are the Main Risks of ETF Investing? The main risks include market risk, tracking error, liquidity, concentration, costs, currency exposure, counterparty risk for some structures and the possibility that a fund changes strategy or closes. These risks are not equally important for every ETF. A broad, physically replicated equity ETF can have a very different risk profile from a leveraged fund, a narrow thematic ETF or a fund investing in less liquid bonds. The first step is to understand exactly what the ETF is designed to do. ## 1. Market Risk An ETF does not remove the risk of the assets it holds. An equity ETF will generally rise and fall with the underlying shares, while a bond ETF can lose value when interest rates rise or credit conditions deteriorate. The diversification provided by a broad fund can reduce company-specific risk, but it cannot eliminate market-wide losses. Investors should consider the volatility and drawdown history of the underlying exposure rather than assuming that the ETF wrapper makes the investment safer. ## 2. Tracking Error and Tracking Difference ETFs often aim to track an index, but their returns can differ from the benchmark. The difference may result from fees, taxes, trading costs, sampling, corporate actions, cash holdings or the way the index is implemented. **Tracking difference** describes the gap between fund and benchmark returns over a period, while tracking error measures the variability of that difference. For investors, persistent underperformance against a straightforward benchmark is worth investigating because it directly affects realised returns. ## 3. Liquidity Risk ETF liquidity has two dimensions. The ETF's shares may trade actively on an exchange, while the underlying securities may be less liquid. In normal conditions, authorised participants and market makers can help keep the ETF price close to its underlying value. During market stress, however, spreads can widen and price discovery can become more difficult. This is particularly relevant for ETFs holding small-cap shares, emerging-market securities, high-yield bonds or other less liquid assets. Investors should consider both the normal bid-ask spread and how the underlying market might behave when liquidity deteriorates. ## 4. Concentration Risk A fund can contain hundreds of securities and still be concentrated. Market-cap-weighted indices may allocate a large share of assets to a small group of companies, while thematic ETFs can be dominated by one industry or investment theme. Counting holdings is therefore a poor substitute for analysing weights. Look at the largest positions, sector exposure, geography and common factors. Several different ETFs can also create concentration when their underlying holdings overlap. ## 5. Hidden Overlap Between ETFs Owning several ETFs does not guarantee diversification. A broad technology fund, an AI-themed fund and a semiconductor ETF may all hold many of the same companies. The investor can end up with a much larger effective exposure to a handful of stocks than the account statement suggests. Look-through analysis is particularly useful here. It allows the investor to see the underlying positions across funds and identify duplicate exposures before adding another product. ## 6. Fees and Implementation Costs ETF expense ratios can be low, but total cost of ownership involves more than the headline annual fee. Investors should consider bid-ask spreads, brokerage costs, taxes, portfolio turnover and tracking difference. A slightly more expensive ETF can still be the better product if it tracks the intended exposure more effectively or offers better liquidity. Comparing only the stated expense ratio can therefore lead to the wrong conclusion. ## 7. Currency Risk International ETFs can create currency exposure even when the investor is primarily thinking about the underlying equities or bonds. A foreign-market ETF can rise in local-currency terms while delivering a weaker result in the investor's home currency if exchange rates move against them. Currency-hedged versions can reduce this exposure but introduce their own costs and implementation differences. Investors should decide whether currency risk is part of the desired allocation rather than treating it as incidental. ## 8. Counterparty and Structural Risk Most traditional ETFs are designed to hold assets that back the fund, but the exact structure matters. Physically replicated funds, synthetic funds, derivatives-based strategies and securities-lending programmes can create different counterparty exposures. Investors should read the fund documentation to understand how the exposure is obtained, whether derivatives are used and what collateral arrangements apply. Structural complexity is not automatically bad, but it should be understood. ## 9. Leveraged and Inverse ETF Risk Leveraged and inverse ETFs are designed to deliver amplified or inverse returns over a specified period, often through derivatives. Their daily objectives mean that performance over longer periods can differ substantially from simply multiplying the underlying index's cumulative return. These products can therefore behave very differently from a conventional passive ETF. They require careful attention to the holding period, volatility and daily reset mechanism. They are generally unsuitable as “set and forget” substitutes for a broad-market allocation. ## 10. Fund Closure and Strategy Change ETFs can be closed or merged when assets remain too small or a provider changes its product range. A closure is not necessarily a sign that investors have lost the underlying assets, but it can create tax, transaction and reinvestment considerations. Investors should also monitor changes to a fund's index, methodology, fees or replication approach. A product can gradually become different from the exposure originally purchased. ## How to Evaluate an ETF Before Buying | Area | What to check | | --- | --- | | Objective | What index, asset class or theme does the ETF target? | | Holdings | What are the largest positions and underlying exposures? | | Concentration | How much depends on a few securities, sectors or countries? | | Tracking | How closely has the ETF followed its benchmark? | | Liquidity | What are the ETF and underlying-market trading conditions? | | Costs | Consider fees, spreads, taxes and tracking difference. | | Structure | Is the fund physical, synthetic, leveraged or inverse? | | Currency | Is foreign-exchange exposure intended or hedged? | ## How ETF Risk Fits Into a Portfolio The most important question is not whether an ETF is risky in isolation, but what it does to the complete portfolio. A supposedly diversifying fund can increase concentration if it overlaps with existing holdings. [Portfolio diversification analysis](https://blog.palance.co/the-power-of-diversification-in-investing) can help identify overlap and correlation, while [portfolio analytics](https://blog.palance.co/understanding-portfolio-analytics) can show the effect on concentration, volatility and drawdown. ## Common ETF Investing Mistakes - Assuming every ETF provides broad diversification. - Choosing purely on the lowest expense ratio. - Ignoring tracking difference and liquidity. - Buying thematic funds without checking concentration. - Overlooking currency exposure in international funds. - Treating leveraged or inverse ETFs like conventional long-term index funds. ## FAQ ### Are ETFs safer than individual stocks? Broad ETFs can reduce company-specific risk through diversification, but they remain exposed to the market and assets they hold. A narrow or leveraged ETF can be considerably riskier than a diversified portfolio. ### What is ETF tracking error? Tracking error measures how consistently an ETF's returns differ from its benchmark. The actual return gap is also affected by fees and implementation costs. ### Can two ETFs be highly correlated? Yes. Different ETFs can hold many of the same securities or share exposure to the same economic factors. ### What is the biggest ETF risk? There is no universal answer. For a broad equity ETF, market risk may dominate. For a narrow or complex product, concentration, liquidity, leverage or structural risk may be more important. ## Conclusion ETFs are efficient investment vehicles, but they are not risk-free wrappers. Investors should understand market exposure, tracking quality, liquidity, concentration, costs, currency and fund structure before buying. The most useful step is to look through the ETF and ask what it actually adds to the portfolio. A product that appears diversified or inexpensive at the surface can create significant hidden exposure once its underlying holdings and implementation are examined. ###### Tags: [ETFs](https://blog.palance.co/tag/etfs) ![Palance](https://blog.palance.co/hs-fs/hubfs/palance_icononly.png?width=50&height=50&name=palance_icononly.png) Post by [Palance](https://blog.palance.co/author/palance) Aug 25, 2023, 3:11:11 PM Developing the world's most powerful portfolio intelligence tool. 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