ETFs EXPLAINED

ETF stands for Exchange Traded Funds. ETFs attempt to track the performance of a specific index - such as the S&P 500 - as closely as possible.

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Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. You may not get back the amount originally invested.

WHAT ARE ETFs?

An Exchange Traded Fund (ETF) is an open-ended collective investment scheme that is traded on one or more exchanges.

Like a fund, an ETF gives access to a portfolio of company shares, bonds or other asset classes, such as commodities or property.

When you buy an ETF, you are actually buying a small portion of a portfolio of securities (such as shares or bonds) built up with the aim of tracking a specific market index and therefore offering the same risks and return as this index.

Investors will experience a similar return as the index tracked, inclusive of the ups and downs of the given index’s performance and accounting for fees.

ADVANTAGES OF ETFs

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You know what you’re getting

ETFs are transparent and show the underlying investments, which is not always the case with mutual funds.

Capital risk: like all investment products, the value of an ETF can go down as well as up. Not all ETFs are suitable for all investors. The price of the investments may go up or down and the investor may not get back the amount invested.
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They offer the best of both worlds

The diversification of a mutual fund with the tradability of a stock.

Income risk: the income associated with a distributing ETF share class is not fixed and may fluctuate.
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There are no surprises

You know that a good ETF will closely track the performance of the underlying index it invests in, though tracking error can be wider for some types of investments due to the given market or fees.

Tracking risk: even after charges are considered, ETFs may not track an index perfectly. The difference between the return of the ETF and the return of the index is called ‘tracking difference’. The variation in daily excess returns between the ETF and the index is called ‘tracking risk’.

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Easy market access

With one holding you get exposure to a whole range of investments. From a single country such as the United States, to global bonds and even commodities like gold there’s usually an ETF for whatever you're looking for.

Taxation risk: The levels and bases of, and reliefs from, taxation can change depending on investors’ fiscal situation.
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They’re cost efficient

And usually much cheaper than mutual funds.

Currency risk: ETFs involving exposure to foreign currencies can be affected by exchange rate movements. This means changes in the value of foreign currencies can impact the value of shares that are bought and sold in that currency. For example, an American investor who buys an ETF that invests in Japanese stocks will see the value of their ETF change if either the price of the stocks changes or if the exchange rate between USD and Yen changes.

There may be other risks that are specific to the exposure of an ETF – for example frontier market risk, sector risk or credit risk. Each ETF issuer should specify these risks in the documentation on their websites. Investors should refer to the ETF documentation before investing in the ETF.

WHICH ETFs ARE THERE?

When selecting an ETF, it helps to consider its structure. The build of the ETF determines how the target index is tracked, what assets you can hold, plus what visibility and risk to expect. Ultimately these impact total cost and projected returns.

There are 2 types of ETFs: Physical ETFs and Synthetic ETFs. We will explore the differences and compare the advantages of both.

Let’s get physical

Most ETFs available today are physical. They are simple to understand and give you good visibility. A physical ETF tracks the target index by holding all, or some, of the underlying assets of the index. For example, a Hang Seng ETF will give you access to either all of the stocks traded on the Hang Seng, or at least a core basket of those stocks.

So, what’s a synthetic ETF?

A synthetic ETF does not invest in assets directly. For example, instead of owning barrels of crude oil, a synthetic ETF tracking oil will hold a series of oil futures contracts. These agreements are set up with a third party, often an investment bank, who promises to pay back an agreed level of return when oil reaches a certain price.

Who would want a synthetic ETF?

Synthetic ETFs are ideal if you want traditionally out of reach assets that are not covered by typical exchanges (think China A shares), or hard to access commodities (like crude oil).

Synthetic ETFs offer potentially higher return than say buying stocks or other tools that involve directly holding the asset. But synthetic ETFs often come with greater risk. Specifically counterparty risk, which is the risk that the counterparty fails to deliver the agreed level return specified in your synthetic ETF.

COMPARING THE GOOD AND THE BAD

Physical Replication

Counterparty risk is the risk that a financial institution – the counterparty – may not be able to pay the index return.

The manager of the funds physically buys and holds all or a representative subset of the shares in line with the index.

Positives: More transparent, easier to understand
Negatives: Can limit access to certain markets and exposures

Synthetic Replication

The manager uses derivatives – a contract between two parties related to a particular asset – rather than physically buying the assets.

Positives: Enables access to markets and exposures that physical replication may not
Negatives: Investors could be exposed to counterparty risk

BUSTING THE 5 ETF MYTHS

When things are hyped like ETFs have in recent years, there are often misunderstandings and a few false truths. Let’s be clear on what ETFs really are and what they are not.

Reality: ETF prices are transparent, but that doesn’t make them more volatile.

The price of an ETF reflects the changing value of its underlying securities and the supply and demand of the ETF in the marketplace. The difference between an ETF and an actively managed fund is that the price of a managed fund, which similarly reflects the value of its underlying securities, is fixed once a day and only after the market closes, while ETF pricing changes throughout the day in real time. This doesn’t mean that ETFs are more volatile – their price changes are just more visible.

Reality: Risk is driven by the assets you're investing in, not necessarily the vehicle used to access the assets.

Just like a managed fund, the risk profile of an ETF is tied to its underlying holdings, or the assets it invests in: so a managed fund and ETF that hold similar stocks or bonds will have similar risk profiles. For example, an international stock ETF or managed fund may have higher risks than a U.S. investment grade corporate bond ETF. But that risk is not related to whether you choose to hold a managed fund or an ETF.

On the flip side, an ETF offers greater diversification than an individual stock, which may help reduce risk in a portfolio.

Although diversification can lower certain types of risk, it cannot fully protect from market risk. Different types of ETF will involve different elements of risk. Before making any investment, it is important to understand the specific risks. Diversification is restricted to the applicable index.

Reality: You can use ETFs for a wide range of exposures and outcomes.

ETFs come in virtually any “flavor” you can think of. They offer low-cost access to specific markets (e.g., a country or industry), AND to broad exposures (e.g. European bond market). This, combined with the ease and speed with which they can usually be bought and sold, means that investors can access investments that may otherwise be out of reach.

So whether it’s hard-to-access foreign markets, core building blocks for your portfolio, or funds that target specific outcomes, there’s an ETF that can help.

Reality: iShares ETFs offer a diverse set of solutions for investors looking for income.

The hunt for income in the low interest rate environment can be challenging. But whether it’s through dividend-paying stocks or fixed income exposures, ETFs offer investors a broad range of opportunities to potentially generate income. And with ETFs, you get the added benefit of greater diversification than an individual stock or bond, all typically at a lower cost than a managed fund.

Reality: ETFs are effective investment tools for many types of investors

Because ETFs have the same trading flexibility as stocks, short-term traders can use ETFs to quickly move in and out of a position. But ETFs are also a cost-efficient way to build a long-term, core portfolio.

ETFs COMBINE THE BEST FEATURES OF STOCKS AND MUTUAL FUNDS

Managed funds (also known as mutual funds) are investment products that pool together money from a range of investors. A fund manager then actively manages and invests this money into a basket of different assets and securities – often stocks. You pay the manager in the hope they drive better performance than the market performance.

While managed funds may offer good returns, in most cases you can’t buy and sell them whenever you want. ETFs, however, act similarly to stocks so you can buy and sell them anytime during market hours.

Although diversification can lower certain types of risk, it cannot fully protect from market risk. Different types of ETF will involve different elements of risk. Before making any investment, it is important to understand the specific risks. Diversification is restricted to the applicable index.

Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. There can be no guarantee that the investment strategy can be successful and the value of investments may go down as well as up. Investment return and principal value of an investment will fluctuate so that an investor's shares, when sold or redeemed, may be worth more or less than the original cost.
ETFs combine the best features of stocks and mutual funds
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