What do I need to know before investing in ETFs and what are the risks?

Exchange-traded funds (ETFs) are tradeable units that have different types of investments all bundled by a professional fund manager into a single investment. In the “bundle” you might have shares, bonds, property investment and other types of investments.

That means people who hold ETFs are investing in a diverse collection of assets across various sectors, markets, companies and regions. With a single ETF you can own a piece of multiple companies or bonds.

They are issued by financial services companies, such as Blackrock, Vanguard, and State Street, and managed by professional fund managers. You can buy and sell units in an ETF fund through a stockbroker; many people use an online broker such as CommSec, CMC Markets, eToro or others.

ETFs can be traded on the Australian Securities Exchange (ASX), or another exchange. The market price of an ETF, which is disclosed daily, will typically follow other benchmarks in the market such as the ASX200 or the S&P500.

ETFs have grown very popular over the last two decades, especially among younger investors. But what are the potential benefits and risks of ETFs?

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What are the potential benefits?

In traditional shares investing, you might research one company and if you believe it will do better, you buy shares in it in the hope its share price rises.

With ETFs, you buy a “bundle” (a number of units) of shares and other securities, that is put together and managed by a professional fund manager. If the market goes up, the value of the ETF should too.

This means investing in ETFs can allow you to spread your risk across a lot of different regions and different markets (such as shares, bonds, property, companies and so on). You aren’t putting all your eggs in one basket. And you can let a professional fund manager worry about selecting the various investments and managing them. You don’t need to be an expert on one particular company or industry.

ETFs also offer flexibility to respond to market trends. They are usually easier to sell quickly than many other types of investments, such as property. This offers freedom to adjust your investment portfolio often and as you like.

Many ETFs that distribute dividends allow the investor to reinvest these dividends automatically to benefit from compound growth over time.

ETFs can also be cost-effective, because the administration is handled by the exchange (such as the ASX).

What are the risks?

Like any investment, ETFs carry risk.

A lot depends on the type of ETF and underlying assets in the “bundle”.

If you aren’t careful, you can end up buying a higher-risk ETF without realising it. So it pays to know what types of investments and in what proportions are in your “bundle” (which is known as your asset allocation).

Asset allocation should be aligned with your risk tolerance. Investors have different tolerances for risk depending on their age, financial goals, investment time horizon, preferences and personal comfort with market volatility. Knowing your risk tolerance helps you manage your emotional reactions during market downturns.

A retiree with a likely low tolerance to taking risks might choose an asset allocation that exposes them to low-risk assets. Someone saving for retirement might have more riskier share investments as they aim to grow their nest egg.

Just like shares, ETFs are subject to market fluctuations. If the market experiences a downturn, then the value of the ETF may decline too (depending on what’s in your ETF). Much of the risk depends on what type of assets the ETFs hold.

And in times of market stress, ETFs may not be as easy as they normally are to convert into cash.

Some financial products bought and sold every day on the market include debts or derivatives (futures and options investments). If your ETFs contain in the “bundle” some debts or derivatives, there is always the risk the party on the other side of a financial transaction may default on their debt obligations.

Growth in Australian exchange-traded funds under the management of a professional ETF manager has been robust in recent years. Market capitalisation stood at A$145.83 billion in October 2023, up 13.55% since October 2022.

But before you dive in, remember that ETFs come with their own risks.

Carefully research and select ETFs that are aligned with your investment goals, preferences, time horizon and risk tolerance or see a professional for advice.

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This article is republished from The Conversation is the world's leading publisher of research-based news and analysis. A unique collaboration between academics and journalists. It was written by: Angelique Nadia Sweetman McInnes, CQUniversity Australia.

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Angelique Nadia Sweetman McInnes has received funding from the Accounting and Finance Association of Australia and New Zealand, Central Queensland University. She is a member of Accounting and Finance Association of Australia and New Zealand, the Financial Advice Association of Australia, the Society for Trusts and Estate Planning, the Financial Planning Academic Forum, Cooperative Research Australia, the Association of Computing Machinery, the Health Informatics Knowledge Management Steering Committee, and the Australasian Society for Computers in Learning in Tertiary Education.