Diploma for Financial Advisers
Diploma in Accounting
Member of London Institute of Banking and Finance

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While ETFs are often marketed as simple and low-cost investments, they come with hidden risks that many beginners overlook. Not all ETFs are created equal, and some can lead to significant losses if you don’t fully understand how they work—should a beginner invest in ETFs? Let’s dive into the complexities and misunderstood risks of ETFs, focusing on leveraged/inverse ETFs, sector/thematic ETFs, and those with derivative exposure.

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Leveraged/Inverse ETFs: A Dangerous Game for Beginners

Leveraged and inverse ETFs are designed for short-term trading, not long-term investing. These ETFs use financial engineering to amplify daily returns—either in the same direction as the market (leveraged) or the opposite direction (inverse). For example, a 2x leveraged ETF aims to double the daily return of an index. Sounds exciting, right? But here’s the catch: they reset daily.

This daily reset creates a phenomenon called “volatility decay.” Over time, even if the underlying index rises, the ETF can lose value due to compounding losses. For instance, if an index drops 25% in a week, a 2x leveraged ETF could lose 50%. And if the index recovers, the ETF might not—because the losses are magnified daily.

The Financial Conduct Authority (FCA) has warned that these products are “high-risk” and unsuitable for most retail investors. Yet, many beginners are drawn to them without understanding how they work, leading to devastating losses.

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Sector/Thematic ETFs: Chasing Trends Without Understanding the Risks

Sector and thematic ETFs focus on specific industries or trends, such as cannabis, artificial intelligence (AI), or robotics. While these ETFs can be tempting—especially when they’re tied to “hot” trends—they come with significant concentration risk.

For example, the Global X Robotics & AI ETF (BOTZ) collapsed by over 60% in 2022. Similarly, the ARK Innovation ETF (ARKK), which gained popularity during the pandemic, fell by 65% in 2022. These ETFs are often heavily concentrated in a few stocks or sectors, making them vulnerable to sharp declines when the trend fades or the market shifts.

Retail investors often chase these trends without understanding the risks. They see past performance and assume the trend will continue, only to be caught off guard when the ETF crashes. The FCA has highlighted that many investors fail to grasp the risks of concentrated investments, leading to significant losses.

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ETFs With Derivative Exposure: Unpredictable and Complex

Some ETFs use complex derivatives—financial instruments tied to assets like oil, currencies, or market volatility—to achieve their returns. These ETFs can behave unpredictably, even for experienced investors.

For example, the ProShares VIX Short-Term Futures ETF (VIXY) tracks market volatility. While it might seem like a good hedge during turbulent times, its value can swing wildly, even if the stock market remains relatively stable. This unpredictability makes it a poor choice for beginners who may not understand how derivatives work.

Derivative-based ETFs often come with high fees and additional risks, such as counterparty risk (the risk that the other party in the derivative contract defaults). The FCA has cautioned that these products are complex and unsuitable for most retail investors.

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Why Beginners Should Think Twice About ETFs

While ETFs are often marketed as simple and beginner-friendly, the reality is that many carry hidden risks. Leveraged/inverse ETFs can lead to massive losses due to daily resets and volatility decay. Sector/thematic ETFs are prone to sharp declines when trends fade. And derivative-based ETFs can behave unpredictably, even in stable markets.

The FCA has repeatedly warned that many retail investors do not fully understand these risks. In a 2022 report, they noted that 45% of ETF buyers didn’t realise leveraged products could lose money even if the market rose long-term.

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Final Thoughts: Should a Beginner Invest in ETFs?

Given the complexities and misunderstood risks of leveraged, thematic, and derivative-based ETFs, beginners should approach these products with extreme caution. While they may seem like an easy way to invest, the potential for significant losses is high—especially if you don’t fully understand how they work.

So, should a beginner invest in ETFs? Not without a deep understanding of the risks involved.

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