Exchange Traded Funds (ETFs) are one of the fastest growing investment products in the world. There are currently 37 ETFs listed on the HKEx and the number continues to expand.
What is an ETF?
- Open-end index funds that are listed and traded on exchanges like stocks.
- Can be bought and sold during normal trading hours, through any broker on most trading platforms.
- Like index funds, ETFs contain groups of securities that are designed to track specific indexes.
Benefits of Using ETFs:
- ETFs track indices which are comprised of a basket of securities, making them inherently diversified.
- ETFs allow you to invest in entire countries or sectors while lessening your exposure to any single stock.
2. Low Cost
- ETFs often have lower fees and expense ratios than comparable index or active mutual funds.
- When buying and trading ETFs, only normal brokerage commissions and fees are applied.
- ETFs are as liquid as its underlying index’s basket of securities.
- When the demand for an ETF rises in the secondary market, new shares are created and placed in the market.
- ETFs generally disclose the exact holdings in the fund as often as daily so you always know exactly what you own.
- ETFs also provide cost transparency through upfront fee disclosure so you know exactly what you are paying for.
Types of ETFs:
- ETFs that hold the underlying securities of the index it’s tracking.
- Usually use a full replication strategy but in some cases, representative sampling is used.
- Full replication cash-based ETFs hold all securities within its underlying index.
- ETFs using representative sampling or optimization strategies hold only a portion of the underlying securities.
2. Swap-based ETFs
- Uses total return index swaps to replicate an index’s performance.
- Can be a good way to gain exposure to markets that cannot be accessed through cash-based funds, such as commodities.
- Involves some exposure to counterparty risk.
Risks of Using ETFs:
Investing always involves some risks and it’s important to understand the specific risks to individual products. The following risks should be considered when investing in ETFs:
1. Market Risk
- Like stocks, prices of ETF shares fluctuate due to various factors. The possibility of market volatility and its impact on security prices should be a consideration for any investor.
2. Tracking Error
- Since ETFs are based on an index or benchmark, there is a chance that there will be a divergence in the return earned by the ETF from the index.
- The divergence between the ETF from the index can be positive, meaning there is profit or negative, meaning the ETF returns less than the index would indicate.
3. Foreign Exchange Risk
- Currency rate fluctuations can affect the value of an ETF’s underlying assets, thus affecting the price of ETF shares.