ETFs

Similar to shares, investors face the risk of substantial loss to their initial investment if market conditions are not favourable.

1. Counterparty risk involved in ETFs with full replication and ETFs with representative sampling strategies

   An ETF using a full replication strategy generally aims to invest in all constituent stocks/assets in the same weightings as its benchmark. ETFs adopting a representative sampling strategy will invest in some, but not all of the relevant constituent stocks/assets. For ETFs that invest directly in the underlying assets rather than through synthetic instruments issued by third parties, counterparty risk tends to be less of concern.

2. Synthetic replication strategies

   ETFs using a synthetic replication strategy use swaps or other derivative instruments to gain exposure to a benchmark. Currently, synthetic replication ETFs can be further categorized into two forms:

   1. Swap-based ETFs

      Total return swaps allow ETF managers to replicate the benchmark performance of ETFs without purchasing the underlying assets. Swap-based ETFs are exposed to counterparty risk of the swap dealers and may suffer losses if such dealers default or fail to honour their contractual commitments.

   2. Derivative embedded ETFs

      ETF managers may use other derivative instruments e.g. access product to synthetically replicate the economic benefit of the relevant benchmark. The derivative instruments may be issued by one or multiple issuers. Derivative embedded ETFs are subject to the counterparty risk of the derivative instruments’ issuers and may suffer losses if such issuers default or fail to honour their contractual commitments.

   Even when collateral is obtained by an ETF, it is subject to the collateral provider fulfilling its obligations. There is a further risk that when the right against the collateral is exercised, the market value of the collateral could be substantially less than the amount secured resulting in significant loss to the ETF.

When the ETF is priced in one currency (eg United States dollar) and is different from the functional currency of the investor (eg Singapore dollar), the investor is exposed to fluctuations in foreign exchange rates, which may increase or erode investment returns on the ETF.

Listing or trading on a stock exchange does not guarantee that a liquid market exists for an ETF. A higher liquidity risk is involved if an ETF uses financial derivative instruments, including structured notes and swaps, which are not actively traded in the secondary market and whose price transparency is not as easily accessible as securities. This may result in a bigger bid and offer spread. These financial derivative instruments are also susceptible to more price fluctuations and higher volatility. Hence, they can be more difficult and costly to unwind early especially when the instruments provide access to a restricted market where liquidity is limited in the first place.

An ETF may be traded at a discount or premium to its NAV. This price discrepancy is caused by supply and demand factors, and may occur during periods of high market volatility and uncertainty. This may be observed for ETFs tracking specific markets or sectors that are subject to direct investment restrictions.

Investors are exposed to market risk or volatility of the specific underlying which the ETF tracks. In unfavourable market conditions (eg market correction or economic crisis) where the general level of stock, bond, or commodity prices decline, the value of ETFs will decline accordingly.

There is a risk that the fund manager of the ETF may not be able to exactly replicate the performance of the underlying. This is known as the “tracking error”. Tracking error may occur due to the (i) methods of sampling are not 100% accurate, (ii) impact of fees and expenses, (iii) foreign exchange differences between the base currency or trading currency of an ETF and the currencies of the underlying investments, or (iv) corporate actions such as rights and bonus issues by the issuers of the ETF’s underlying securities.

Specifically for overseas ETF, investors may be dealing with foreign Governing Laws and Jurisdictions. Transactions on markets in other jurisdictions, including markets formally linked to a domestic market, may expose you to additional risks. Such markets may be subject to regulations which may offer different or diminished investor protection. Before you trade, you should enquire about any rules relevant to your particular transactions. Your local regulatory authority will be unable to compel the enforcement of the rules of regulatory authorities or markets in other jurisdictions where your transactions have been effected. You should ask the firm with which you conduct your transactions for details about the type of redress available in both your home jurisdiction and other relevant jurisdictions before you start to trade.

Inverse ETF fund managers may, at times, be unable to fully carry out their short-selling strategy as a result of difficulties in the derivatives markets, regulatory restrictions, or their inability to locate and borrow shares or for other reasons. This could cause the market price of the ETF to vary from its index target and NAV.

For example, if fund managers are unable to carry out their short-selling strategy they may not be able to offer shares that are sufficient to satisfy market demand. This could cause the ETF shares to trade at a premium to (or higher than) the fund’s NAV.

Many leveraged ETFs (of both the long and the short varieties) rely on the use of futures, swaps and other derivative securities, along with other securities or commodities, to achieve their target results. Some of these derivatives, such as swaps, are unlisted securities that depend on the swap issuer’s ability to pay. Therefore, the leveraged ETFs that depend on such swaps may not be able to achieve their stated result if a swap counterparty should default.

Leveraged and inverse ETFs may be less tax efficient than other ETFs. It is possible for investors to have a tax liability, even in a year in which the leveraged or inverse ETF had a negative overall return. This outcome can result from the fund managers “rebalancing” the investments each day with derivatives to maintain the ETF’s multiple. Such rebalancing can produce realized taxable gains with no offsetting losses. As with any potential investment, an investor should consult with his or her tax advisor and carefully read the prospectus to understand the tax consequences of leveraged or inverse ETFs.