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September 15, 2011
EXCHANGE Traded Funds (ETFs)
have become popular with inves-
tors and they are often promoted
as an easy way to diversify your
investments, usually with lower fees than
traditional managed funds.
Be warned though, some ETFs are com-
plex and risky investments.
As ADF members know, higher poten-
tial returns usually come with higher risks.
You need to understand the risks and keep
within a level you are comfortable with.
What are ETFs?
ETFs are promoted as a low-cost way to
get investment returns similar to a share index
or another underlying asset.
They are a type of managed investment
that can be bought and sold like shares,
through your stockbroker or online trading
The ETF usually tries to match changes
in the value of an equities index, but ETFs
are also available that offer exposure to
assets such as international shares, foreign
currencies and even precious metals.
Two types of ETFs
Most ETFs buy the shares and other
investments that they are trying to match --
they are known as standard or physical ETFs.
While you will not personally own the
shares the ETF buys, you will usually own
units or shares in the ETF.
Your main investment risk is the perfor-
mance of the ETF's underlying shares and
Another type of ETF, known as a syn-
Weigh up the risks on
Exchange Traded Funds,
says Australian Securities
and Investment Commission
chairman Greg Medcraft. ETFs explained
Email ASIC at ADFcol
topics that interest you
thetic ETF, may or may not directly own the
underlying shares or other assets and uses
complex products called derivatives and
swap agreements to track their performance,
In Australia, only a handful of synthetic
ETFs are available. They are required to
include the word 'synthetic' in their title,
so you can easily identify them, and other
rules have been introduced to reduce some
of their risks.
Risks to consider
These are some of the complex features,
which can apply to physical ETFs, synthetic
ETFs and sometimes both.
TRACKING ERRORS: Physical ETF
prices will not exactly follow the price
of the index or investments they are
designed to track. This 'tracking error'
may be caused by fees, taxes, and other
factors. The extent of any tracking error
with a synthetic ETF depends on its spe-
PRICING ERRORS ('gapping'): ASIC
has found examples of ETF prices quoted
by online stockbrokers that are signifi-
cantly above or below the value of the
assets that the ETF holds. The risk is that
you might pay far more than the ETF's
assets are worth, or sell ETFs at a price
far below the value of their assets.
OVERSEAS INVESTING: If the ETF
tracks international shares or other
investments, there may be currency, tax
and pricing risks.
COSTS: While ETFs have become
known for low costs, management fees
vary and there are other costs to consider.
For example, some ETFs' management
fees may be higher than the fees for an
equivalent (unlisted) index fund.
COUNTERPARTY RISKS: Synthetic
ETFs enter into contracts with third par-
ties, or counterparties. Your returns are
dependent on the counterparty being able
to honour its commitment to the ETF.
SECURITIES LENDING: Physical and
synthetic ETFs may use securities lend-
ing, transferring some of their assets
(such as shares) to other companies for
a fee. The risk is the borrower will not
return the securities as promised.
Finally, whenever you invest, remember
the importance of diversification, or spread-
ing your investments to control your risks.
For a more detailed list of risks to consider
before investing, go to www.moneysmart.
gov.au and search for 'ETFs'.
Photo: CPL Aaron
What you need to
know before investing
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