by Donavan Lim
The exchange traded fund is defined by Investopedia “as a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.”
ETFs have gained noted popularity among investors as the funds are marketed on the virtues of lower costs and ease of trading as compared with mutual funds.
A swift glance on the Singapore Exchange will show the proliferation of these funds. Names such as ABF Singapore Bond Fund and iShares MSCI Singapore Index Fund should be familiar to retail investors.
Unfortunately, familiarity with the funds does not always translate into knowledge. Investors are generally not attuned to the inherent danger of these funds.
What are the Risks?
For the initiated, ETFs are generally grouped as synthetic or physical.
Physical ETFs are funds that attempt to track an index through the direct purchase of the underlying assets. Whereas synthetic ETFs invest in derivatives in order to replicate a fund performance.
Synthetic ETFs are subjected to counterparty risk associated with the derivative issuers and may face losses if the issuers fail to honour their obligations.
This is very real possibility of a default scenario in situation of extreme stress or black swan event as some will term it. Although in theory, all UCITs (Undertakings in Collective Investments in Transferable Securities)-compliant funds are required to limit their risk of 10 per cent of their portfolio to a singular counterparty, these counterparties could easily have underlying links with each other, ensnaring everybody in a web of financial liability or what we call knock-down effect. This was exactly what happened at AIG in 2008.
Synthetic ETF can be distinguished from physical ETF on Singapore exchanges through the x included in their name. For example: DBXT S&PShort10US$x@ is a synthetic ETF.
The second risk is currency risk. As we all know, most currencies are managed on a floating basis leaving potential for gains or losses. Needless to say, investors should be well prepared for losses if they purchase ETFs that track foreign funds.
Last but not least is the tracking error risk, which is simply the difference the performance of an ETF and the underlying benchmark. In a perfect world, of course the replication of performance of an index can be done without error. But since we live in a less than perfect world, errors do occur. Tracking error arises due to a number of reasons including management fees, other fees such as audit expenses, etc.