How risky (or not) are ETFs?

The biggest risk of ETFs: market risk

No return without market risk

Fundamentally, investing always involves taking on some risk, with the hope of earning a return. The relationship between risk and return is a foundational concept in finance. This type of risk is called "market risk", because it's the risk associated with simply investing in the financial markets.

When you invest, you give up the safety of a low-risk, low-return product, like a savings account. But you're compensated for taking on that extra risk with a higher return. Conversely, if there's no risk involved, there's little reason to expect any return. This is why the return of an ETF is, in the long run, much higher than the interest on a savings account.

ETFs are less risky than stocks

As an investor, you face two types of risk: specific risk and systemic risk. Specific risk refers to the risk unique to a particular company. Think, for example, of Volkswagen's emissions scandal, BP's Deepwater oil rig disaster, or Wisecard's fraud affair.

You can reduce specific risk by diversifying, investing in many companies and sectors. This is because you limit the impact of one company's poor performance on your overall investment portfolio, as other investments can perform well and offset losses. And the great thing about ETFs is that they're inherently diversified, because they let you invest in hundreds or thousands of companies in one go. So ETFs eliminate the specific risk that you have when investing in individual stocks.

Systemic risk affects the whole market, not just a particular company. It arises from factors that affect the whole market, such as major economic events. Diversification cannot eliminate systemic risk because it affects all investments, no matter how diverse your investment is. But as an investor, you are happily rewarded for taking systemic risk, in the form of higher returns compared to safe investments.

In short: with stocks, you're exposed to both specific and systemic risk. But ETFs eliminate specific risk because of diversification. You just keep systemic risk, for which you are rewarded with a higher return.

Finding out the market risk of an ETF

ETF providers are required to include a risk rating in an ETF's Key Investor Document (KID). It's a number between 1 and 7, 1 being the lowest risk and 7 the highest risk. Although not perfect, it's a good first indication of how much risk (and therefore return) you can expect from an ETF. You can find the KID on the ETF's page on website of the provider.

Controlling the market risk with ETFs

We cannot exclude market risk from investing in ETFs. Because that would come at the expense of the return we're hoping to get. The good news is that you can control how much market risk you're willing to take. You can dial the risk-return knob up (higher risk, higher return), or down (lower risk, lower return).

By building a portfolio of different ETFs, each with different risk characteristics, you can tailor the risk and return of your investments to your financial goals and investor psychology. You don't want to take on too much risk, where you risk getting in a situation where you panic and sell all your investments (the one mistake the investor cannot make!). At the same time, if you take too little risk, you may not be able to reach your financial goals. This is also a form of risk. Building the right portfolio of ETFs for you is an entire topic on its own.

Other risks of ETFs

Market risk is the most important risk when investing in ETFs. But there are others worth mentioning, although they play a smaller role. And sometimes it's possible to eliminate them:

• Currency risk: If you’re investing in an ETF that tracks foreign markets, you will be exposed to currency risk. However, this is usually a good thing when investing for the long-term because it provides additional diversification.
• Counterparty risk for synthetic ETFs: Some ETFs, especially synthetic ETFs, rely on financial derivatives and have counterparty risks if the other party defaults.
• Counterparty risk when your broker lends your ETFs: Some brokers, especially the cheaper ones, earn additional revenue by lending out your ETFs. This can result in a risk that the borrower can't repay your ETF.
• Sector risk: Some ETFs focus on specific sectors (e.g., technology, healthcare). If that sector underperforms, the ETF might face larger declines than broader market ETFs. You can eliminate that risk simply by diversifying across many sectors, as we'll show in the example below.
• Tracking error: The discrepancy between an ETF's performance and the performance of its underlying index.
• Leverage: Some ETFs are designed to amplify returns using leverage. These ETFs are riskier than traditional ETFs, and we don't think they're suitable for most investors.
• Liquidity risk: Even though ETFs are traded like stocks, not all ETFs are highly liquid. Some niche or specialized ETFs might have lower trading volumes, which can result in wider bid-ask spreads and price volatility.

Example of a risky ETF: Lyxor Nasdaq 100 Daily (2x) Leveraged

First, let's look at an example of an ETF considered risky: Lyxor Nasdaq 100 Daily (2x) Leveraged (FR0010342592). It's risky because of several aspects:

• Concentrated in a single country: The Nasdaq-100 index only tracks technology companies listed on the American Nasdaq stock exchange. This means your investment is entirely concentrated in the US, which exposes you to the risk of anything bad happening to that country.
• Concentrated on a single sector: Only technology companies. The tech industry has outperformed other industries the last few years, but it's unknown if this trend will continue in the future.
• Synthetically replicated: There's a counterparty risk with synthetic replication, that you don't have with physical replication.
• Leveraged: It aims to replicate two times the daily return of the Nasdaq-100 index. Just as gains can be amplified, losses are magnified as well. If the underlying index moves against the position of the ETF, the losses can be severe.

Example of a less risky ETF: iShares Core MSCI World

The iShares Core MSCI World ETF (IE00B4L5Y983), also known by its ticker IWDA, is in many ways less risky than the leveraged Nasdaq-100 ETF above. Instead of being concentrated on a single sector in a single country, it tracks over 1,500 companies across 23 countries and all industries. It's also physically replicated, and does not use leverage. It's more boring, but we think good investing should be boring! Based on historical data of the underlying MSCI World index, IWDA has delivered an average yearly return of 10.1% between 1978 and 2024.

Mythical risk: the ETF running away with your money

A common fear among investors is losing their entire investment if the fund provider or another party goes bankrupt. Fortunately, strong regulatory frameworks have been built over the past centuries to protect individual investors. As a result, although these risks can never be fully ruled out, they are largely theoretical.

Risk of bankruptcy of the ETF provider

As with traditional investment funds, ETFs have to place their underlying investments with a custodian. The fund provider cannot be both the fund manager, and the "guardian" of the assets. So if an ETF provider goes bankrupt, your investments are not gone cause they will still be kept by the custodian. This separation is imposed by the European regulatory framework that governs financial services. In the event of a bankruptcy, another provider will then take over management of the fund.

Risk of bankruptcy of the custodian

Can the custodian go bankrupt though? In the EU, a series of regulations and protective mechanisms aim to prevent them from going bankrupt or, if they do, to ensure that client assets remain protected. In fact, there has never been a case in the EU where a major custodian for ETFs went bankrupt.

A cornerstone of the EU's asset protection framework is the requirement that custodians keep client assets separate from their own. This ensures that, in the event of bankruptcy, client assets (such as the holdings of an ETF) are not accessible to the bank's general creditors and can be returned to the rightful owners. Custodians are also liable in the case of the loss of a financial instrument held in custody. They can only delegate their liability under specific circumstances, ensuring a high level of responsibility for asset protection.

Risk of delisting

It happens that an ETF closes. After all, funds become profitable only after they reach a certain scale. In that case, the assets in the fund are simply sold and you get back the full value of the ETF at that time.

Mythical risk: losing your entire investment

If you diversify across all sectors and countries through an ETF like IWDA, it's very, very unlikely your investment will become worthless. Because it would mean that all major companies in the world have gone bankrupt. At that point, you, and humanity as a whole, probably have larger worries than their portfolio of ETFs.

Is a savings account really safer than an ETF?

For many people, the financial markets are something scary and risky. In contrast, the good old savings account at the bank is seen as boring, but safe. This popular view isn't entirely correct though.

A savings account is unlikely to help you meet your financial goals

A savings account pays out a fixed interest that is set by the bank. It doesn't fluctuate like an ETF, and so doesn't have market risk. But that also means that the returns of a savings account is very low. All throughout the 2010s, inflation was mostly higher than the interest rate paid by your bank. This means that by keeping your savings on a savings account, you were effectively losing money every year. That isn't going to help you meet your financial goals in the long term. In contrast, an ETF like IWDA earned an average return of 12.9% between 2010 and 2020, delivering a significant return on top of inflation. And over the last 100 years, stocks have yielded an average 6.6% return per year after inflation.

You can lose your money with a savings account

We saw earlier that when you buy an ETF, it is kept at a custodian and nothing happens to it. It just stays there, under the guardianship of the custodian. But this doesn't happen when you put your money in a savings account and entrust it to the bank. The money doesn't just stay there. The bank spends most of your savings almost immediately, for instance to loan it out to a couple who's buying their first home, or to a company that needs capital to grow faster. The bank can also invest your money.

Of your savings, the bank keeps only a little behind. After all, you expect that if you go to the ATM today and withdraw €100, the bank will be able to give you your full €100. The bank needs to create the illusion that it has all the money on your savings account (which it hasn't cause it has loaned most of it out).

The system works as long as everyone keeps believing in this illusion. But it's a very unstable equilibrium. The system breaks as soon as people stop believing in it. Then they will all rush to get their money out, but the bank will not have all the money. In such a bank run, a few savers will then see their pennies back, but the vast majority will lose everything, unless the government steps in to compensate savers. Such scenarios regularly play out, for instance in 2023 when the US Silicon Valley Bank went bankrupt in less than 72 hours.

In practice, this difference between ETFs and a savings account has major implications. During the 2008 financial crisis, Iceland's Kaupthing bank collapsed. Belgian savers with money in that bank had to wait for months until the French, Luxembourg and Belgian governments had an agreement to bail them out. This was because the bank had long since "invested" their savings in junk loans of US real estate, which later turned out to be worthless.

By contrast, customers with investment funds with the Icelandic bank saw their capital appear in a securities account with Crelan just two weeks later. After all, Kaupthing had entrusted their investments to a depository institution. In other words, even after the bank failed, all the customers' investments were still there, untouched.

Invest safely in ETFs through Curvo

We built Curvo to simplify investing with ETFs. When you invest through the Curvo app, your investments are managed by NNEK, a Dutch investment firm. They are licensed by the Dutch regulator (AFM) and are under their strict supervision. So your investments are safeguarded by strict regulations.

When you create an account, you are asked questions to determine your financial goals and learn more about your risk profile. Based on your answers, you are matched with the ideal portfolio for you. These portfolios were built to minimise the risks associated with ETFs. They're globally diversified, they use physical replication, they don't use leverage, and they exclude the companies that are worst for the planet.

Learn how Curvo can help you prepare for your long-term financial future.

What you should do now

1. Are you aware of the market risk inherent to investing, and are you convinced of the relative safety of ETFs?
2. If so, ask yourself if you wish to manage your own investments through a broker, or make your life a bit easier with an app like Curvo, which was built to simplify all the complexities of index investing. You can use our comparison to help you decide.

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. And even though a savings account carries no market risk, it's likely that it won't be sufficient to reach your financial goals. And that is a risk too.