Have you ever invested in ETFs or other investment products that are linked to the performance of ETF(s) (e.g. equity-linked investments, equity-linked deposits, funds that invest in ETF(s))? Are you attracted by the advertised benefits of ETFs, such as gaining access to restricted markets (e.g. China A-share market), or to ride on the general sector / regional movement instead of taking a view on any particular stock or asset? If your answer to any of the above questions is “yes”, you should read on to ensure you are aware of the major risks of ETFs and related products.
Different Replication Strategies in Achieving the Index Tracking Objectives
The common feature of ETFs is that they track indices. To achieve the index tracking objective, an ETF fund manager may adopt one or more of the following three strategies: (i) full replication by investing in a portfolio of securities that replicates the composition of the underlying index1; (ii) representative sampling by investing in a portfolio of securities featuring a high correlation with the underlying index, but not exactly the same securities as those in the index; or (iii) synthetic replication through the use of financial derivative instruments to replicate the index performance2. You may have noticed that some ETFs listed on the Stock Exchange of Hong Kong (SEHK) have a marker "X" at the beginning of their stock short names, an asterisk (*) and an annotation "(*This is a synthetic ETF)" right after their names. These specifications denote that synthetic replication applies to these types of ETFs.
Major Risks of ETFs
The major types of risks of ETFs are highlighted below. Investors, as well as intermediaries, should bear in mind that these risks apply to ETFs and also to investment products that invest in or are linked to the performance of ETF(s).
Applicable to ETFs in general:
Additional risks applicable to synthetic ETFs in particular:
Synthetic ETFs do not invest directly in the underlying assets which constitute the index but seek to obtain an exposure to the economic gain / loss in the performance of the index (net of fees and charges) by entering into derivatives contracts with counterparties. Therefore, synthetic ETFs have additional risks when compared with ETFs of other replication strategies and investors should be aware of the risks before making an investment decision.
Reminder for Investors
Did you find the major risks of ETFs listed in the above section too technical to understand? Or did you just skip the whole section because it appeared too lengthy? If so, you have to think twice whether ETFs and their related investment products are suitable for you before you decide to invest in such products.
As a rule of thumb, investors should read the relevant offering documents of the investment products and ensure they understand the key product features and related risks before making an investment. For ETFs that are listed on SEHK, details of the ETF, such as the offering document, financial statements, notices and announcements, as well as the investment objective, replication strategies, exposure to each of the derivative counterparties, and information of collateral, where applicable, are usually made available on the ETF’s own website. For ETFs that are listed on overseas stock exchanges, investors should seek clarification from their intermediaries on whether and how such information can be made available to them.
Investors should also note that ETFs listed on overseas stock exchanges may not have the same specifications as described above or any specifications at all in their names to differentiate synthetic ETFs from ETFs of other replication strategies. Besides, the synthetic ETFs listed on overseas exchanges may have more complex structures, such as the use of derivatives to adopt an inverse and / or leveraged3 strategy which may not be suitable for general investing public. Investors should consult their own financial advisers for independent financial advice if in doubt.
Executive Director (Banking Conduct)
14 August 2011
3 Leveraged ETFs seek to deliver multiples of the performance of the index they track. Inverse ETFs seek to deliver the opposite of the performance of the index they track. They are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis.