ETFs use a diversity of investment strategies and as such are complex investments with enhanced opportunity for risk. Here are some questions to ask before investing in ETFs.
How does the ETF fit into your overall investment strategy?
ETFs can provide diversification and may help enhance a balanced portfolio. That said, there are many risks inherent in ETFs that need to be considered in the context of your risk tolerance, level of investment knowledge, time frame and overall holdings. The type of ETF that you choose, if any, should be researched, considered and discussed with a trusted adviser before being added to your investment portfolio.
What market does the ETF invest in, and what is the benchmark index?
Understanding the benchmark index and the market that the ETF is investing in, as well as how that corresponds to your investment goals and objectives is very important. You should also be aware of the market cycles and underlying risk factors related to the area of the market youíre investing in.
Do you understand the underlying investments?
Look at the benchmark index that the ETF follows, as well as the underlying securities. Make sure you are comfortable with these securities and that their weighting in the ETF corresponds with your investment strategy and values.
Is the ETF leveraged?
This is an important question to consider. Leverage is a strategy that uses various financial instruments and borrowed money, in an attempt to increase the potential return of an investment. If the ETF is leveraged, while your gains will be magnified when the investment goes up, you need to be aware that your losses will be compounded. Additionally, price volatility is a risk of leveraged ETFs.
Leveraged investments have heightened risk, and are not suitable for everyone. The prospectus will outline the type of leverage and how it is used.