The Ins and Outs of Market Risk
May 21, 2026
Broadly speaking, risk in the investing context is the possibility that an individual or institution may not reach their goals. There are many risks to be aware of — interest rate risk, geopolitical risk, counterparty risk, and more.
Let's put those portfolio threats aside and focus on the Investment and Market Risks associated specifically with ETFs. There are a number of risk metrics investors can use to see whether or not a given ETF is meeting its objective. It's important to know what these metrics are — and it's equally crucial to understand what constitutes a good number, and what suggests cause for concern.
"To use a baseball analogy, knowing what slugging percentage represents is only half the battle — the savvy fan can put a player's figure in context and make an informed conclusion about how good a hitter someone truly is. The same logic applies to ETF risk metrics."
Is Your ETF Doing Its Job?
Although active ETFs have become more prevalent, the most popular funds are still passively managed. Whether or not a passive ETF increases or decreases in value, it's crucial to know whether the fund is "doing its job." In other words: is a given passive ETF reflecting its benchmark index, or meaningfully straying from it?
This is where a metric known as Tracking Difference can be used. Tracking Difference is the discrepancy between ETF performance and index performance over a specified period of time. For passive ETFs, Tracking Difference is arguably the most important risk metric to follow.
The Importance of Tracking Difference
Every ETF will have some element of Tracking Difference. For one thing, an ETF's total expense ratio (TER) can always be expected to contribute to Tracking Difference, as it creates an exact drag on the fund's performance compared to its index. Investors obviously benefit from a lower TER, as this minimizes the gap between an ETF's performance and its benchmark index.
📊 Tracking Difference Illustrated
A chart of NAV Total Return vs. Index Return over a 4-year period (2021–2024) illustrates how Tracking Difference measures the gap between what the ETF returned and what its index returned. A consistent, narrow gap is a sign of a well-managed fund.
A fund's Tracking Difference can also be impacted by:
Cash Drag
In a bull market, a portfolio that holds cash will tend to underperform an index with no cash component.
Sampling
Some ETFs engage in Full Replication — owning all components of an index. Others 'sample' a majority of the index components, owning most but not all of its securities. By not fully replicating an index, an ETF is exposed to Tracking Difference (positive or negative).
Securities Lending
Many ETFs earn extra income by lending out shares to short sellers. This can improve a fund's performance, but it introduces risk: if a lent security soars and the short seller is bankrupted, the borrowed shares may not be returned. To protect lenders, lent securities are always collateralized using cash or securities.
Trading Costs
When an ETF buys or sells securities (to rebalance, for example), it incurs trading commissions. These costs also cause the ETF's performance to deviate from that of the index.
From Tracking Difference to Tracking Error
Tracking Difference is a measure of whether an ETF is keeping up with its index, but Tracking Difference fluctuates over time. That's where Tracking Error comes in. Tracking Error is essentially the volatility of an ETF's Tracking Difference — the lower the number, the better.
Tracking Error shows you if the tracking difference is relatively consistent, or if it varies wildly over the course of the year. Some investors conflate Tracking Difference with Tracking Error — they see a high Tracking Error and conclude that an ETF isn't properly following its index. In reality, the Tracking Difference may simply be low but volatile.
For the purpose of Tracking Difference and Tracking Error calculations, an ETF's performance can be measured by price or Net Asset Value (NAV). NAV may have fewer uncontrollable variables, arguably making it the better choice for comparison.
Other Passive Measures of Risk
In addition to Tracking Difference and Tracking Error, there are two other key metrics used to measure ETF risk for passive ETFs:
Beta
A measure of an ETF's volatility relative to the market. The overall market's Beta is 1.00 by definition. An ETF with Beta > 1.00 has been more volatile than the market; Beta < 1.00 means less volatile. A negative Beta means the ETF moves inversely to the market (e.g., inverse ETFs, government bond ETFs).
Standard Deviation
Compares the long-term average return of an investment to its shorter-term returns. A low Standard Deviation indicates more consistent returns. Crucially, Standard Deviation captures both upside and downside volatility — a high number could indicate increasing or decreasing returns, or a combination of both.
Suppose two ETFs both average a 7% return over the past 10 years. When looking at individual years, one returned 7% every year while the other had some years with double-digit performance, and others with low single-digit returns. Clearly, the ETF that rose 7% each year displayed lower volatility — and likely took less risk to achieve the same long-term return.
📉 NAV vs. Standard Deviation (2021–2024)
A dual-axis chart showing NAV growth alongside Standard Deviation over time demonstrates how volatility can shift even when returns trend upward. Investors benefit from monitoring both metrics together to get a complete picture of risk-adjusted performance.
Active Measures of Risk
Passive ETFs may still dominate, but active products are becoming increasingly popular with investors. As with passive ETFs, investors can use both Beta and Standard Deviation when judging whether an active product is meeting its objective. In addition, there are two key risk metrics specifically applicable to active ETFs:
Alpha
A measure of how an ETF performs relative to a particular index or benchmark over a specified period, after adjusting for volatility. Expressed as a percentage, Alpha offers a window into 'active' performance. For example, an ETF with an Alpha of 3% will have exceeded its benchmark by that amount after accounting for volatility.
Sharpe Ratio
A measure of an ETF's excess returns relative to its volatility — indicating how much excess return is generated per unit of risk taken. A higher Sharpe Ratio implies an investor is being well-compensated for taking extra risk. Anything above 1 is generally considered good. Ideally, an ETF delivers above-average returns with low volatility.
Sidebar: Liquidity Risk
ETF investors are also faced with potential liquidity risk. This is especially true if a significant portion of a fund's assets are concentrated in thinly-traded securities. An ETF's liquidity is tightly linked to the liquidity of its underlying holdings.
"A fund that has a large weighting in small companies with large bid-ask spreads and low volume will usually have poorer liquidity than a fund which predominantly owns large-capitalization stocks with tighter spreads and high daily volume."
Bottom Line
ETFs have specific roles to play in an investor's portfolio. There's no guarantee that a given ETF will rise in value, as any number of market factors could lead to a decline. But whatever the market environment, it is crucial that the ETF is performing its role correctly.
Investors should look at the key risk metrics for a given fund to see whether the ETF is truly "doing its job." That can help determine whether it's a hold, or if it's time to sell and move on to a product more likely to meet their objective.