Investing is risky. That shouldn’t come as a surprise. The market is fickle. It fluctuates up and down, many times for no good reason.
How exchange-traded funds deal with those risks plays a big role in assessing their long-term merit. Regardless of what the market does, well-constructed investment strategies are intentional about the risks they incur and compensate investors with an appropriate rate of return. But not all ETFs pull off that feat successfully. More and more ETFs are amplifying risks and falling short of expectations.
Consistency Is Key
Good investment strategies typically distinguish themselves from bad ones through their ability to consistently deliver on their targeted risks. For example, a broad market index fund, like iShares S&P 500 ETF IVV, is very consistent. It’s up 1% when the S&P 500 is up 1%, and down 1% when the S&P 500 is down 1%. It never fails to track the S&P 500, so it’s very easy to understand the risks you’re taking.
IShares Core S&P US Value ETF IUSV, which has a Morningstar Medalist Rating of Silver, goes one step further in the risks it incurs. It is a value ETF that holds a few hundred stocks from the cheaper half of the US market. It should outperform the market when stocks with cheaper multiples outperform those with more expensive multiples. Likewise, it should underperform under the opposite conditions.
IShares Core S&P US Value ETF has consistently delivered on those expectations. Exhibit 1 shows its growth relative to iShares S&P 500 ETF. It outperformed iShares S&P 500 ETF when the line slopes upward, and it underperformed when the line slopes down. A flat line means neither ETF had an advantage over the other.
IShares Core S&P US Value ETF underperformed iShares S&P 500 ETF over the first nine months of 2020 and over the trailing 30 months through May 2025. Big growth-leaning technology stocks like Apple AAPL, Microsoft MSFT, and Nvidia NVDA were the winners over those periods, while cheaper stocks struggled. IShares Core S&P US Value ETF underperformed the market in a way that was consistent with expectations of a value-oriented portfolio. IShares Core S&P US Value ETF’s consistency carried over to periods it outperformed as well. It beat iShares S&P 500 ETF by 12.8 percentage points in 2022, when cheaper stocks held up better as the broader market declined.
Too Far
Not all value-oriented ETFs can live up to those expectations. One example is iShares Focused Value Factor ETF FOVL. Like iShares Core S&P US Value ETF, it holds stocks from the cheaper side of the market, but it holds just 40—a lot less than the hundreds in iShares Core S&P US Value ETF’s portfolio. As a result, it looks very different from iShares Core S&P US Value ETF, and that can influence how it performs.
Exhibit 2 shows the relative growth of iShares Focused Value Factor ETF relative to iShares S&P 500 ETF alongside iShares Core S&P US Value ETF’s chart from Exhibit 1. Plotting both side-by-side more clearly shows the similarities and differences between these two value strategies.
Both followed the same basic pattern of a value portfolio. They both underperformed iShares S&P 500 ETF over the first nine months of 2020, outperformed it in 2022, and then lagged the market over the 30 months through May 2025.
But big differences emerge over shorter periods. For example, iShares Focused Value Factor ETF lost 23 percentage points more than iShares Core S&P US Value ETF during the 2020 drawdown. It gained some of that back over the ensuing six months, while iShares Core S&P US Value ETF was flat. Finally, it lagged iShares Core S&P US Value ETF by 3.9 percentage points in 2022.
Said another way, iShares Focused Value Factor ETF’s performance was more erratic than iShares Core S&P US Value ETF’s. Anyone that opted for iShares Focused Value Factor ETF endured a rocky ride, and they weren’t compensated for that additional risk. IShares Core S&P US Value ETF beat iShares Focused Value Factor ETF by almost 2 percentage points annualized from the day iShares Focused Value Factor ETF launched in March 2019 to the end of May 2025.
Active Risk
IShares Focused Value Factor ETF’s performance illustrates an important lesson: It’s easy for an ETF to take on additional risk, but it’s much more difficult for it to compensate investors with an incremental rate of return.
IShares Focused Value Factor ETF took on more risk by narrowing its portfolio down to a select group of 40 stocks. Its return depended more on the success or failure of the individual stocks it held and less on the performance of cheap stocks more broadly. IShares Core S&P US Value ETF looks different from the market, but iShares Focused Value Factor ETF looks very different from the market.
Analysts use the term “active risk” to broadly describe the magnitude of the differences between investment portfolios. Often, those differences are expressed through tracking error: a metric that summarizes how closely an investment tracked its benchmark, like its Morningstar Category index. Qualitatively speaking, a low active risk portfolio typically has low tracking error relative to its benchmark. A high active risk portfolio incurs more tracking error, meaning its total return deviates with a greater frequency and magnitude from the same benchmark.
IShares Core S&P US Value ETF and iShares Focused Value Factor ETF are both value strategies that hold large- and mid-cap stocks, so the Russell 1000 Value Index is an appropriate benchmark to assess their tracking error. The tracking error of iShares Core S&P US Value ETF relative to the Russell 1000 Value Index was 2.3% over the trailing five years through May 2025, while iShares Focused Value Factor ETF’s weighed in at a hefty 10.1%. IShares Core S&P US Value ETF is an example of a low active risk ETF that should perform a lot like the Russell 1000 Value Index. On the other hand, iShares Focused Value Factor ETF is a high active risk ETF, and it may deviate from that benchmark in ways that are difficult to predict.
FOMO
Do high active risk portfolios provide any long-term benefit? A 2019 Morningstar paper titled Portfolio Concentration Doesn’t Have Much Sway on Returns investigated the relationship between an actively managed portfolio’s concentration and its subsequent performance. It found funds that held relatively fewer stocks experienced higher highs and lower lows. Furthermore, the chance that a highly concentrated portfolio outperformed its benchmark was about the same as a more diverse portfolio, but the range of outcomes was much wider. Some outperformed by a lot, while many others tanked.
In other words, highly concentrated portfolios were much riskier than their more diverse counterparts, and a concentrated portfolio didn’t really pay off with higher returns (on average). The study didn’t incorporate index-tracking ETFs, but they can suffer from the same problems. Whether active or passive, concentrated portfolios are much more dependent on the performance of a small subset of stocks. That makes it very difficult, if not impossible, to predict when a concentrated portfolio will deviate from its benchmark, or if those deviations will help or hurt investors. The market can go down and individual stocks can go up, or the market can go up and individual stocks can go down.
Thematic ETFs, whose popularity has soared over the past few years, are a great example of high active risk investments. ETFs like Negative-rated ARK Innovation ETF ARKK performed spectacularly well over the second half of 2020, only to fall from grace soon after. Similar ETFs hold a small number of stocks that are in some way exposed to a specific economic theme, such as technological innovation, artificial intelligence, or weight-loss drugs, to name a few. Compelling stories and assertive marketing typically accompany them, but they seldom live up to the hype. Occasionally, some of these ETFs can produce impressive short-term returns. ARK Innovation ETF was no exception in that regard, and that can cause many to fear that they’re missing out on what looks like a tremendous opportunity. But stellar performance from highly concentrated portfolios rarely persists. They eventually run into problems. Most have lousy long-term performance and eventually shut down after speculators lose interest.
Exhibit 3 came from the 2024 edition of Morningstar’s Global Thematic Funds Landscape report. It shows that the long-term performance of thematic funds has been dismal. A little less than half had shut their doors before turning 10 years old, while less than 20% went on to outperform the global stock market. Those success rates get worse when the lookback period extends to 15 years.
All this points to one of the unsung advantages of broadly diversified ETFs. By design, they hold a small piece of every stock in the market. That reduces opportunity costs, or the poor performance an ETF endures from not holding the right stocks at the right time.
Asset managers have introduced more and more highly concentrated ETFs over the past few years. Some are thematic like ARK Innovation ETF. Others, like iShares Focused Value Factor ETF, fit the strategic-beta mold. The common thread is that they all hold relatively few stocks.
In many instances, introducing such ETFs is a conscious effort to offer an investment that differs from the broad-market ETFs currently dominating investors’ portfolios. They’re also an excuse to charge higher fees. Buyer beware. Any stock ETF with fewer than 100 holdings is a red flag. And even those meeting that threshold should be heavily scrutinized. Remember, just because these highly concentrated, high active risk ETFs are available doesn’t mean you have to invest in them.