Risks of ETFs

Date: August 14, 2017

Some of the risks associated with investing in ETFs include:

Investing for longer than the Intended Tracking Period: Inverse or short ETFs are intended to track the movements of a short index. The short index moves inversely to its corresponding long index on a daily basis. This means that the performance of the short index may differ greatly from the inverse performance of the long index when measured over a period of more than one day. These ETFs are generally not intended for long term investments and are generally not suitable for retail investors who plan to hold them for longer than one day, particularly not in volatile markets. Investors should familiarise themselves with the investment objective in the prospectus to see if the specific ETF they intend to invest in is meant to track indices only on a daily basis.

Market Risk: Investors are exposed to market risk or volatility of the specific benchmark which the ETF tracks. For example, the performance of an ETF tracking the STI will be directly affected by the price fluctuations of the constituent stocks of the STI.

Counterparty Risk: Where an ETF uses a swap or participatory note structure, investors are exposed to counterparty risk. This means that in the event of a bankruptcy or insolvency of the counterparty, the ETF could incur significant losses. For some ETFs registered as UCITS III, this loss could be limited to 10% of their total NAV, but for others, this loss could be much larger.

Tracking Error: The fund manager of the ETF may not be able to exactly replicate the performance of the specific benchmark due to various fees, investment constraints, timing differences and other factors. This is known as tracking error. As a result, the change in the NAV of the ETF may not exactly follow the price changes of the benchmark.

Market Price not reflecting NAV: The NAV of the ETF may itself be different from the market price, which is affected by demand and supply. The designated market maker works with the fund manager to create new units or redeem units to meet market demand and bring the market price in line with the NAV of the ETF. However, this may not erase the difference between the market price and the NAV entirely.

Foreign Exchange Risk: For ETFs denominated in foreign currencies, investors should be aware that foreign exchange rate fluctuations may affect the returns if they wish to receive their returns in Singapore Dollars. In addition, some of the assets of the ETFs may not be denominated in the same currency the ETF is traded in.

Liquidity Risk: As with all investments, investors should be aware of liquidity risk – the risk arising from difficulty in buying or selling units in an ETF. Liquidity in ETFs is usually provided by a market maker who will provide continuous bid-ask prices throughout the trading day. However, in the event that the market maker fails to perform its duty due to insolvency or other considerations, liquidity in the ETF is not guaranteed. The ETF may then have a large spread between bid-ask prices. However, unit trusts generally have better liquidity as the fund manager is legally bound to redeem units on each dealing day, except in extreme circumstances described in the prospectus.