Like all stock market investments the value of an exchange traded investment will rise or fall and neither the capital nor income is guaranteed.
Anyone investing in an exchange traded investment must accept these are relatively new and "unproven". The high risk nature of exchange traded investments was exemplified in 2008 when the American insurance company, AIG, failed and dealing in a number of Exchange Traded Commodities (ETCs) was effectively suspended for a week.
Below we describe some of the more common risks, but before you invest please read the prospectus for the exchange traded investment you are considering. Exchange traded investments may not be suitable for all investors. If you are unsure of their suitability please seek advice.
Exchange traded investments seek to replicate the performance of an index, currency or commodity. However, after accounting for charges, cash drag, and the other factors described below, there will always be a difference between the performance of the exchange traded investment and the investment it tracks. This difference is referred to as the tracking error. When the market is volatile the tracking error is likely to be higher than normal. Occasionally, a tracking error may benefit the investor but it often works against them.
Types of tracking error
The provider will levy an annual charge for managing the exchange traded investment. Other charges, such as dealing costs for acquiring and disposing of the underlying investments, will also be charged to the exchange traded investment. If the underlying investments track the market accurately, and there are charges involved, the performance of a tracker will fall behind that of the index.
Some indices contain shares which can be difficult to deal. These are typically smaller companies’ shares or companies listed in emerging markets. However, it can affect any company where the value of shares traded daily is low. The provider may choose to ignore these companies and instead purchase larger companies within the same index which can be acquired more easily. No two shares perform in the same way and the divergence in performance creates the tracking error.
When dividends or other cash payments are received the exchange traded investment may hold cash. The cash may receive a small daily interest payment but this is unlikely to match the return if that money had been invested.
The constituents of an index can change and the Excahnge Traded Fund (ETF) provider will need to restructure the ETF. This can carry transaction charges and there may also be a delay between the index being updated and the date on which the ETF’s holdings are changed. Both of these factors can create a disparity.
Exchange traded investments that use the futures market to track, short or leverage an index, commodity or currency will need to rebalance the underlying holdings on a daily basis to reflect price movements and the new weightings of the index. Every time a fund is rebalanced a tracking error occurs, which over time can have a material effect on the performance of the fund.
Rolling future positions
There are two types of commodity exchange traded investments; those that track the ’spot’ price of a commodity directly and those that attempt to replicate the movement using the futures market.
The spot price is the market price. When newspapers report that crude oil has risen beyond $100 a barrel or gold has risen beyond $1,000 an ounce, they are usually referring to the spot price.
Exchange traded investments which track the spot price typically hold the physical commodity. They track the spot price because the manager can buy and sell the commodity in the market to meet demand.
Some commodities lend themselves more easily to this method of replication than others. Gold, for example, is easy to buy and store. However, in some cases holding the underlying physical commodities would be extremely difficult. Wheat, for example, would spoil if held for any length of time, and the costs of storing millions of barrels of oil would be prohibitive. Therefore, rather than taking delivery of the physical commodities, and tracking the price directly, some exchange traded investments use the futures market to gain exposure to movements in the price. Please note however, the use of futures is not confined to commodities which are difficult to store. Each exchange traded investment’s prospectus offers details.
A future is a contract that allows someone to buy a fixed amount of a specific commodity at a set date in the future.
The price of a future often offers a good proxy to the spot price, but they do not always move in tandem. The futures price can differ from the spot price for a number of reasons, for example interest rates, the cost of storing a commodity, and market expectations. For example, if oil has a spot price of $100 per barrel and it costs $2 per month to store and insure a barrel of oil, the futures price for delivery of a barrel of oil in a month’s time may be $102.
The situation where the futures price is higher than the spot price is known as ’contango’, and the opposite is known as ’backwardation’.
Contango in particular causes problems for exchange traded investments which use futures contracts. Most futures contracts expire on a rolling monthly basis and, as it costs significantly more to store and insure a barrel of oil for a month than for a day, these costs fall as the end of the contract approaches and the price of the future moves towards the spot price.
In this example, which assumes the spot price remains at $100 per barrel, an exchange traded investment purchases a futures contract for one barrel of oil which expires in a month’s time for $102. After a month, the exchange traded investment will need to ’roll-over’ the futures contract – effectively selling the old future and buying a new one for a month’s time. If the old future was not sold, the exchange traded investment would have to take delivery of the physical oil (which it has no need of). The futures contract purchased for $102 has reduced in price to $100 as it nears expiry. The cost of a new contract is $102, so the exchange traded investment has made a loss of $2 even though the spot price has remained constant.
Exchange traded investments do not always hold the physical assets. They may use futures and options to provide exposure. If the investment bank providing the option fails, the exchange traded investment will lose part or all of the money it has invested with that institution (Lehman Brothers is the obvious example).
Exchange traded investment providers can generate further revenue by lending holdings to other institutions. The third party institution will pay for the loan and part of this payment will be made into the exchange traded investment and part retained by the provider. If the third party were to fail, and the exchange traded investment is unable to recover its holdings, investors would suffer a loss.
As an example of counterparty risk, a number of ETCs were temporarily suspended in September 2008 as the futures used to price the ETCs were provided by AIG, an American insurance company, which failed. This caused the market makers, who essentially determine the quoted price of the shares, to suspend dealing until the US Government stepped in to support AIG. In light of this issue many exchange traded investment providers revised their collateral policy in an attempt to reduce possible counterparty risk. Investors should check the providers’ prospectus for further details and ensure they are comfortable with the arrangements before they invest.
Conflicts of interest
Conflicts of interest can arise with synthetic exchange traded investments when a bank has the dual role as ETF provider and derivative counterparty. In this case the exchange traded investment provider is, in effect, buying the contract from itself, and can set out the terms of the contract itself. As the bank can set and agree to the contracts without external intervention, a conflict of interest could arise between the performance of the exchange traded investment and the revenue to the bank. The prospectus of the exchange traded investment will detail the counterparty used and also any potential conflicts of interest. Potential investors should ensure they are comfortable with the arrangements before they invest.
If the exchange traded investments’ underlying holdings are in a currency different to the denominated currency, investors will face currency risk.
Short and leveraged exchange traded investments are more complicated investments which carry greater risk. Leveraged investments will exaggerate market movements and therefore be very volatile, carrying a higher level of risk and potential reward.
Most leveraged exchange traded investments work on a double leverage basis so that if the price of the underlying index/commodity rises by 1% in a day then the corresponding exchange traded investment will rise by 2% in a day (excluding costs). Equally, if the index falls by 1% then, all other things being equal, the exchange traded investment will fall by 2%. Therefore losses can be accumulated much more quickly than traditional investments. However, it is not possible to lose more than you invest.
Leveraged ETFs are intended for institutional and sophisticated investors and you should read the prospectus carefully and ensure you are comfortable with the risks before you invest.
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. Other more mainstream exchange traded investments will also experience volatility but it’s likely to be to a lesser extent.
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 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.
More on the risks of ETFs
The prospectus will give more information on the risks of the exchange traded investment you’re interested in.