Exchange-traded funds are a core part of many investors' portfolios. But they carry some unique risks you may not have thought of.
ETFs carry market risk, or the risk that prices will go up and down. This is true of any type of investment. But here are two other ETF risks that can seriously damage your portfolio -- and what to do about them.
Beware of ETFs That Use Derivatives and Leverage
To stand out in an increasingly crowded field, ETF providers have created increasingly exotic ETFs -- some of which are very risky. This includes leveraged and inverse ETFs.
Leveraged ETFs are designed to earn returns that are two or three times that of their underlying index. The ProShares UltraPro Short S&P 500 (SPXU) is one example. Its mandate is to earn three times the opposite of what the S&P 500 returns in a day. So, this ETF would go up 3% if the S&P 500 loses 1% in a day.
An example of an inverse ETF is the ProShares Short S&P 500 ETF (SH) . It aims to do the opposite of what the S&P 500 does, but without the leverage. So, if the S&P 500 climbs 1%, this ETF loses 1%, and if the S&P 500 loses 1%, SH climbs 1%.
Leveraged and inverse ETFs both use derivatives. As the name implies, a derivative's value is "derived" from the price of an underlying asset, like oil, silver or a stock index. Derivatives are used by ETF managers to mimic or amplify a target index's returns.