Exchange Traded Funds
As ADF members you deal with risk every day. It’s impossible to avoid all risks when you invest. Higher potential returns usually come with higher risks. The important thing is to understand the risks and then keep within a level you are comfortable with.
Exchange Traded Funds (ETFs) have recently become popular with investors and they’re increasingly being recommended by financial advisers. They’re often promoted as an easy way to diversify your investments, usually with lower fees than traditional managed funds. However, some ETFs are complex and risky investments.
What are ETFs?
ETFs are promoted as a low-cost way to get investment returns similar to a share index or another underlying asset. They are a type of managed investment that can be bought and sold like shares, through your stockbroker or online trading account. The ETF usually tries to match changes in the value of an equities index, but ETFs are also available that offer exposure to assets such as international shares, foreign currencies and even precious metals.
Two types of ETFs
Most ETFs buy the shares and other investments that they are trying to match – they’re known as standard or ‘physical ETFs’. While you won’t personally own the shares that the ETF buys, you will usually own units or shares in the ETF. Your main investment risk is the performance of the ETF’s underlying shares and other assets, though other risks are discussed below.
Another type of ETF, known as a ‘synthetic ETF’, may or may not directly own the underlying shares or other assets and uses complex products called derivatives and swap agreements to track their performance, before fees. In Australia, only a handful of synthetic ETFs are currently available. They’re required to include the word ‘Synthetic’ in their title, so you can easily identify them, and other rules have been introduced to reduce some of their risks (see Counterparty risks, below).
Synthetic ETFs may be used by investors when it’s impossible or expensive to buy, hold and sell the underlying investment in another way. Synthetic ETFs’ prices should closely match changes in the value of their underlying investments with minimal ‘tracking error’, before fees and taxes.
Risks to consider
ETFs may appear simple and transparent, but they can be complex investments. Below are some of the complex features, which can apply to physical ETFs, synthetic ETFs and sometimes both.
- Tracking errors: Physical ETF prices will not exactly follow the price of the index or investments they are designed to track. This ‘tracking error’ may be caused by fees, taxes, and other factors. The extent of any tracking error with a synthetic ETF depends on its specific features. For example, the prices of some types of synthetic ETFs available overseas, such as ‘inverse’ and ‘leveraged’ ETFs, will diverge from their benchmarks when held for longer than a day. These types of synthetic ETFs are not currently available in Australia.
- Pricing errors (‘gapping’): ASIC has found examples of ETF prices quoted by online stockbrokers that are significantly above or below the value of the assets that the ETF holds. The risk is that you might pay far more than the ETF’s assets are worth, or sell ETFs at a price far below the value of their assets. Before placing an ETF order, check the price you’re quoted matches what the ETF issuer says its assets are worth (the ‘net asset value’, or NAV). Some ETF issuers’ websites regularly update their estimated NAVs.
- Overseas investing: If the ETF tracks international shares or other investments, there may be currency, tax and pricing risks
- Costs: While ETFs have become known for low costs, management fees vary and there are other costs to consider. For example, some ETFs’ management fees may be higher than the fees for an equivalent (unlisted) index fund. ETFs’ ‘buy-sell spread’ (the respective prices that you can buy and sell ETF units at) vary. You should also consider what fees you’ll pay your stockbroker or online trading account (usually at least $20-$30 per trade) to buy or sell ETF units.
- Counterparty risks: Synthetic ETFs enter into contracts with third parties, or counterparties. Your returns are dependent on the counterparty being able to honour its commitment to the ETF. For synthetic ETFs currently available in Australia, the counterparty must be an Authorised Deposit-taking institution or a foreign equivalent (or an entity with an irrevocable guarantee from an ADI or equivalent).
- Securities lending: Physical and synthetic ETFs may use ‘securities lending’, transferring some of their assets (such as shares) to other companies for a fee. The risk is the borrower will not return the securities as promised. While some ‘loan’ security (collateral) is usually provided, risks remain.
- Some are not really ETFs: Some structured investment products may ‘look and feel’ like ETFs, as they also track share indexes or other investments. They may have names such as Exchange Traded Commodities, Notes, Certificates or Securities, but these structured products are not the same as ETFs. The counterparty risks with some structured products may be much higher than with ETFs, because the rules for those products are not the same as the ASX requirements for synthetic ETFs.
Finally, whenever you invest, remember the importance of diversification, or spreading your investments to control your risks. This includes putting money into different types of investments and with a range of financial institutions. If you are investing in ETFs, consider using several different ETF providers.
For a more detailed list of risks to consider before investing, go to www.moneysmart.gov.au and search for ‘ETFs’.
E-mail ASIC with topics that interest you via ADFcolumn@asic.gov.au.
Australian Securities and Investments Commission