Risks of investing in Exchange Traded Funds (ETFs) and Exchange Traded Commodities (ETCs)

Warning: The following is a list of some of the important risks factors that prospective investors should consider prior to making a decision to invest in ETFs or ETCs. The list is not intended to be comprehensive or exhaustive. Various other risks also apply, depending on the ETF or ETC acquired. You should ensure that you read and fully understand the relevant Prospectus, Supplement and Key Investor Information Document, including the risks associated with the investment prior to making a decision to invest. You should also consult Davy Select in the event that you require further information or have any queries in relation to same.

The Relationship between Risk and Return

Risk is an inherent part of investing. Generally, investors must take greater risks to achieve greater returns; however taking on additional risk does not always lead to greater returns. Investors, who take on additional risk, must be comfortable with experiencing significant periods of underperformance in the expectation of achieving higher returns over the longer term. Those who do not bear risk very well have a relatively smaller chance of making high earnings than do those with a higher tolerance for risk, similarly they have a smaller chance of making significant losses. It's crucial to understand that there is an inevitable trade off between investment performance and risk. Higher returns are associated with higher risks of price fluctuations.


It is important to establish your attitude to risk before you begin investing.  Is the security of your capital the overriding influence in your investment decisions or are you willing to tolerate the ups and downs of the market in the expectation of higher returns?


Although not always the case, generally speaking, the level of return on your investments will reflect the underlying risk. If you’re only willing to accept low or zero levels of uncertainty, your investment returns are also likely to be low. However, an investment that seems very attractive in terms of its potential return may not be the right choice if it carries an unacceptably high risk. High risk investments generally require that the investor has the ability to hold it for the longer term (5-10 years), in order to allow shorter term performance issues time to resolve themselves. Importantly, investors should remember, however, that accepting high levels of risk does not always result in high returns.


Not all investment decisions will turn out as expected, but diversification can be a key tool in managing risk. By acquiring a portfolio of varied investments across a range of asset classes (Shares, Bonds, Cash, etc), geographies and sectors, investors can minimise the effects which poorly performing investments can have on their overall portfolio. This diversification theory applies within asset classes as much as at portfolio level.


There are specific risks which investors should be aware of when investing in certain asset classes. The following section deals with some of the risks which apply when investing in Exchange Traded Funds and Exchange Traded Commodities


Index Risk

ETFs are designed to match an index, and are passive investments. Because an ETF is not actively managed, it will not sell a security if the security's issuer is in financial trouble—unless the security is removed from the index. This means that the Exchange Traded Fund will move up and down with the index and the Exchange Traded Fund manager will not take defensive positions, or sell losing positions, in a market downturn. This also means that the manager won't increase exposure to positions that it anticipates increasing in value, either. This lack of management means that investors are placing their money with an index, not a manager, and their fortunes are related to the performance of the index. The best way for an investor to deal with index risk is to understand what is in the index and the rules governing what goes into, or out of the index, as covered in the Exchange Traded Fund's documentation.


Tracking Error

In addition to the risk of their investment being exposed to the movements of the index, investors also are at risk when the ETF or ETC does not match the performance of the index, a situation known as tracking error.


Tracking error represents the difference between the performance, or return, of the ETF or ETC's portfolio and the underlying index. Tracking error occurs for a number of reasons. The first is that an ETF or ETC has expenses that an index does not have, because it incurs costs when it buys and sells securities. The frequency of these transactions, such as how often a Exchange Traded Fund rebalances its portfolio, can increase the costs that increase tracking error and diminish an ETF or ETC's performance.


Another reason for tracking error occurs when an ETF or ETC holds cash, which will earn a different rate of return than ETFs or ETCs invested in the portfolio and cause a deviation in returns between the index and the ETF or ETC. (At some times the cash may perform better than the ETF or ETC.) With ETFs and ETCs, however, the amount of cash held tends to be small.


Certain ETFs may exhibit tracking error because the weights of the securities in their portfolios do not match those in the ETF. When the weights are based on market capitalisation, this will not be much of a problem, because the weights are tied to the capitalization of the stocks, and if a stock moves up in price in the index, that will be captured in the ETF. The difficulty arises when an ETF assigns weights by another means, such as equal weighting or some arbitrary method of weighting. In these cases, changes in the values of the securities in the index may not show up in the Exchange Traded Fund until the ETF is rebalanced, where the ETF's securities are adjusted to match those in the index. This lag can induce tracking error.


Another source of tracking error comes from the fact that many ETFs or ETCs do not hold all the securities that make up the index. There are two ways for an ETF or ETC to track an index. The first is replication, whereby the ETF or ETC holds all the securities in an index in the same proportions as in the index. The second is by representative sampling, whereby the ETF or ETC uses a sampling methodology to select securities that it believes will provide the same performance as the entire portfolio. This methodology usually produces larger tracking errors than if the ETF or ETC bought the whole index. The amount varies depending on the quality of the sampling process.


Counterparty risk

Exchange Traded Funds/Commodities do not always hold the physical assets. If the investment bank providing the future/option fails, the Exchange Traded Fund will lose part or all of the money it has invested.


Currency

If the exchange traded investments' underlying holdings are in a currency which is different to the denominated currency, investors will face currency risk.


Volatility

ETCs are generally higher risk investments because commodity prices can move by more than 10% in a single day. Movements of this order are unusual, but they do occur, and are further magnified by leveraged or geared exchange traded investments.


Trading within foreign market closures

Exchange Traded Funds and Commodities traded on a particular exchange can be bought or sold between normal market opening hours, typically 8am to 4.30pm. However, many of the indices an ETF or ETC might track might be open outside the exchange on which the ETF or ETC is listed. This means the ETF or ETC is trading during periods when the underlying index is closed. This can result in a disparity between the daily performance of the ETF or ETC and the index being tracked.


Tax

The tax treatment of an exchange traded investment is subject to change, which could affect your investment in the future. In some cases, the returns from trading ETFs and ETCs may potentially be subject to income tax rather than capital gains tax. The ongoing tax liabilities are determined by both your individual circumstances and the continued status of the exchange traded investment. If you are unsure of your tax liabilities you should consult a qualified tax advisor.


Other risks include, but are not limited to, the following:

  • Investors may not benefit from the same entitlements as if they held the shares directly (e.g. voting rights).
  • Costs can be significant and can be difficult to define precisely. While the annual management charge may be stipulated, other charges may be less visible.
  • Investors cannot control the investments that are made within the ETF. This discretion is held by the Investment Manager appointed by the third-party investment Exchange Traded Fund provider.
  • Although an ETF may be denominated in a particular currency, underlying investments may be held in other currencies and thus the ETF may be subject to currency moves.
  • ETF prices can be volatile. The overall market may fall, or the ETFs that you invest in may perform badly. The value of your investment may go down as well as up. Past performance is no indication of future performance.
  • Counterparty risk should be considered when acquiring ETCs in particular, as Exchange Traded Funds invested are generally held with a counterparty. While funds invested in Exchange Traded Funds may also be held with a counterparty, they are generally invested in securities.