7 Risks To Consider, 6 Factors To Weigh

Foreword from ShareInvestor

This article “7 Risks To Consider, 6 Factors To Weigh” by Lorna Tan was first published in The Straits Times on 14 Oct 2018 and is reproduced in this blog in its entirety

7 Risks To Consider

Not all exchange-traded funds (ETFs) are created equally; some have more complex structures and are exposed to more risks. As with all investments, buy into an ETF only if you are comfortable with its structure and potential risks. ETF risks are fundamentally determined by the performance of the underlying holdings, the volatility and risk of the markets or sectors in which the ETF invests and the investment style it follows, says DBS Vickers Securities.

1. Market Risk

You are exposed to market risk or volatility of the specific underlying asset or market the ETF tracks. This risk cannot be diversified and during adverse conditions when prices of stocks, bonds or commodities decline, the ETF’s value will decline accordingly, adds DBS Vickers Securities.

2. Foreign Exchange Risk

Investors are exposed to fluctuations in foreign exchange when the ETF is priced in a different currency from the investor’s local currency. This can potentially increase or erode returns.

3. Liquidity Risk

This refers to the inability of the investor to exit the ETF if there are no available buyers in the market, says Mr Jeffrey Lee, managing director and chief investment officer at Phillip Capital.

DBS Vickers Securities says market makers provide liquidity through a continuous bid-ask process throughout the trading day. However, if there are adverse market conditions, the ETF units in the secondary market may have wider bid-ask price spreads, which may make it hard for investors to sell ETF units.

4. Tracking Errors

The ETF’s fund manager may be unable to replicate the underlying performance well. The difference between the index and ETF returns are generally due to management fees and timing differences.

5. Risk In Synthetic ETFs

Some of the ETFs are replicated synthetically. This involves the use of derivatives, for example, Equity Linked Swaps and China A-share Access Products. Investors in such ETFs are exposed to counter-party risk. If the counter-party defaults, even if the underlying index is unaffected, investors could incur significant losses, says DBS Vickers Securities.

6. Leveraged ETFs

Mr Kelvin Goh, head of investments and wealth advisory at OCBC Bank, warns retail investors against investing in leveraged ETFs, which have gained popularity in recent years. These ETFs employ leverage to boost the returns of the underlying asset class.

“While performance may be boosted, the flip side is also true should the performance of the underlying assets fail,” he says.

7. No Guarantees

Like most investment products, returns are not guaranteed.

6 Factors To Weigh

Here are things to consider when investing in ETFs:

1. Investment Objectives

Consider your investment aims before putting your money in any product. As an ETF has a specific strategy in terms of style, sector or geography, investors need to be aware if the investment objective is in line with their personal objectives.

For instance, retail investors looking for both dividends and capital gains can check out the new Phillip SING Income ETF from Phillip Capital Management.

2. Dividends

Most ETFs offer dividends, which come from the underlying stocks. These are collected by the fund manager and redistributed to investors on a quarterly or semi-annual basis.

ETF fund managers will determine if dividends are better utilised via re-investing or distributed as income to investors. An investor should look into the distribution policy as specified in the prospectus and refer to the dividend announcements made by the fund manager.

Dividends are paid out in the same way as you would receive dividend payments from stocks. Note that not all ETFs pay dividends.

3. Different Options

Before investing in ETFs, it is important to examine liquidity, expenses and charges, tracking errors, market and currency risks, ETF structure and the sponsor, along with the performance track record.

Mr Lee advises that as two ETFs tracking the same index are expected to deliver the same performance, the cheaper one would be a better choice as fees eat into investment returns. And if two ETFs show the same tracking error, the one with the lower error would be better.

DBS Vickers Securities says an investment decision should not be driven by simply chasing the highest past performance.

4. Active and Passive Management

Ask yourself if you are looking at tracking an index or to outperform it, says Mr Goh.

Proponents of active investing attempt to beat the market by seeking outperformance from actively managed funds, while those of passive investing believe in lower fees and delivering whatever the market returns are – good or bad.

The two strategies have their own merits. Depending on market conditions and investment objectives, fund managers may choose one strategy over another.

Launched last year, the Lion-OCBC Global Core Fund is an actively managed fund of ETFs.

In the case of the Phillip SING Income ETF, it picks 30 Singapore stocks that have a track record of growing dividends and earnings, so investors can count on stable dividend income as well as potential capital appreciation, says Mr Lee.

Combining both strategies can further diversify a portfolio, manage overall risk and potentially help to optimise risk-adjusted returns and improve overall fund performance. The recently launched LionGlobal All Seasons Fund is one product that combines active and passive investment strategies.

5. Utilising Retirement Savings To Invest In ETFS

You can use your Central Provident Fund (CPF) to buy selected Singapore Exchange-listed ETFs.

To do so, open a CPF Investment Account with an agent bank and link it to your trading account. However, you can invest funds only in excess of $20,000 in your CPF Ordinary Account and $40,000 in your CPF Special Account.

For SPDR Gold Shares, only 10 per cent of excess investible savings in your Ordinary Account can be used.

There are four SGX-listed ETFs you can buy using your CPF – ABF Singapore Bond Index, SPDR STI ETF, Nikko AM STI ETF and SPDR Gold ETF.

6. Utilising Supplementary Retirement Scheme (SRS) Money To Buy ETFs

You can use funds in the SRS account to buy into all SGX-listed ETFs. Do note that the settlement currency for all SRS trades must be the Singdollar.