Some market observers warn that ETFs could be more dangerous than shares in a crash. The biggest risk is one shares carry too: the market falling. Whether ETFs amplify sell-offs on top of that has not been conclusively shown either way.
ETFs have become the preferred investment vehicle for many UK retail investors in recent years, and that success brought the criticism with it. So which risks does an ETF actually carry?
The biggest ETF risk in a crash is the market itself
An ETF carries the same risk as the shares it tracks. If the underlying index falls, the ETF falls too: a FTSE 100 tracker drops with the FTSE 100, and a global tracker drops with world markets. It makes no difference whether you would otherwise have held the shares directly or invested through an actively managed fund.
You cannot diversify this general market risk away by choosing a different investment vehicle. You can only soften it by spreading your money across different asset classes.
Do ETFs amplify downward moves? The claim and the interconnection worry
Whether ETFs amplify downward moves is disputed among market observers, and there is no conclusive evidence either way. Critics of the growing market weight of ETFs worry that a sell-off already underway could intensify if sellers of ETF shares are not matched by enough buyers. In a panic-driven selling wave, ETFs could then become a bottleneck in theory and amplify the prevailing trend, which in a downturn means the downward one.
This risk is not limited to ETFs, though. The same dynamic applies in principle to individual shares and actively managed funds: if many people want to sell at once in a genuine crisis, they may also have to accept unreasonably low prices.
A related criticism concerns how ETFs, derivatives such as swaps, and the widespread practice of securities lending tie the finance industry together. The worry is that very tight interconnection could let problems at individual market participants spread through the whole system faster in a crisis. How high this risk really is, is hard to say. There is no conclusive evidence on this either.
What protects your money in an ETF crash, and what does not
Two separate layers matter here, and neither covers price falls.
At fund level, most ETFs sold to UK investors are UCITS funds. Some are UK authorised and regulated by the FCA, while many are domiciled in Ireland and authorised by the Central Bank of Ireland. In both cases the fund's assets are entrusted to a depositary for safekeeping, rather than held by the fund manager. They are kept separate from the manager's own assets, so the manager's insolvency should not reach your fund holding. This applies to physically and synthetically replicating ETFs alike.
At platform level, if you hold ETF shares through an FCA-authorised firm, the FCA's client asset (CASS) rules require it to safeguard your assets, in particular if the firm itself becomes insolvent. If a shortfall remains, the Financial Services Compensation Scheme (FSCS) may compensate eligible investors: for a firm that failed after 1 April 2019, up to £85,000 per eligible person per firm. The FSCS is explicit that it cannot accept claims for poor investment performance. Holding an ETF in a Stocks and Shares ISA changes how it is taxed, not how much market risk it carries.
These protections address failures of firms. Price losses from normal market movements are a different kind of risk and are not compensated.
Segregation does not remove every counterparty risk, though. Synthetic ETFs track the index through a swap with a counterparty, usually a bank. If it defaults, the ETF can suffer losses. UK UCITS rules cap exposure to a single swap counterparty at 5 percent of fund assets, or 10 percent where it is an approved bank, and provide for collateral. That reduces the risk but cannot eliminate it.
Physically replicating ETFs that lend out securities carry a residual risk too: if the borrower defaults and the collateral is worth less than the securities lent, a loss can result.
What long-term investors can take from this
A few basic principles help a portfolio hold up in a crisis: well-known, broad, liquid indices instead of complex niche products, holdings spread across several fund providers, and no panic-selling in a genuine downturn.
A price drop only becomes a realised loss once you sell. Historically, contrarian behaviour, meaning not selling when everyone else is, has generally paid off for long-term investors. That is no guarantee for the future.
Set your position size before the crisis
No ETF structure removes market risk, so the variable you control is the size of each position. Choose one from the start that you can hold through a significant price drop without panicking.
With Axiomly's free position size calculator, you can work that out in advance for every position you take.