What You Should Know about Exchange Traded Funds (ETFs)

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:

• Market risk – investors are exposed to the political, economic, currency, and other risks of a specific sector or market related to the underlying index;
• Liquidity risk – liquid secondary market may not exist for ETFs;
• Tracking errors – changes in the net asset value of the ETFs may deviate from the performance of the tracking index due to factors such as fees, expenses, liquidity of the index constituents, failure of tracking strategy;
• Passive investments – unlike other funds, ETFs are usually passively managed and will not adopt defensive position against any market downturn;
• Trading risk – ETFs may trade at premium or discount to its net asset value due to secondary market trading factors such as market demand and liquidity;
• Potential conflicts of interest – the subsidiaries and affiliates of the ETF manager may also play a role in the ETF which may give rise to potential conflicts of interest;
• Concentration risks – ETFs may invest in single country and sector;
• Emerging market risk – ETFs with tracking index relating to emerging markets may be subject to a greater risk of loss than investments in developed markets due to, among others, greater political, economic, taxation and regulatory uncertainty risks; and
• Tax and other risks – like all investments, an ETF may be subject to tax imposed by the local authorities in the market whose index it tracks and is subject to the risk of change in policy of the reference market.

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.

• Credit risks arising from derivatives counterparties – investors are exposed to the credit risk of the derivatives counterparties. In the event of default by any counterparty, the ETF may be suspended, and the shares of the ETF may not continue to trade. The ETF may ultimately be terminated. Investors may suffer significant losses equal to the full value of the derivatives net of any collateral provided;
• Potential concentration and contagion risks of counterparties – the derivatives counterparties are predominantly financial institutions and this, in itself, may pose a concentration risk. Any adverse event affecting the performance of a particular derivatives counterparty may also have a negative impact on the performance of others due to the contagion effect;
• Collateral risks – while some synthetic ETFs may hold, or have recourse to, collateral to mitigate the exposure to credit risks of the derivatives counterparties, the collateral may not comprise any constituent securities of the index. The collateral may also be concentrated in particular market(s), sector(s) and/or securities issued by specific sovereign or public issuer(s) which may not be related to the underlying index. Furthermore, when an ETF seeks to exercise its rights against the collateral upon any default of counterparties, the market value of the collateral could be substantially less than the amount secured if the market drops sharply before the collateral is realised, thereby resulting in significant loss to the ETF; and
• Higher liquidity risk – higher liquidity risk is involved if the derivatives that a synthetic ETF invests in do not have an active secondary market.

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.

Meena Datwani
Executive Director (Banking Conduct)
14 August 2011

¹ A total of 27 non-synthetic ETFs were listed in the Stock Exchange of Hong Kong as at 30 June 2011, of which the Tracker Fund of Hong Kong attained the highest turnover value in June 2011.

² A total of 49 synthetic ETFs were listed in the Stock Exchange of Hong Kong as at 30 June 2011, of which iShares FTSE A50 China Index ETF attained the highest turnover value in June 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.