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Benefits and risks

It’s important to consider how exchange traded funds (ETFs) fit in to your overall portfolio. As with any investment, ETFs involve risk. Generally, the higher the expected return of an investment, the higher the risk and the greater the variability of returns

Benefits of investing in ETFs

ETFs make it easy to gain direct exposure to a wide range of investments with a single trade.  ETFs are issued by a professional fund manager with access to information, research and investment processes that may enable them to offer better returns or reduce risk. 

ETFs are traded on the ASX and this means that you can buy and sell during ASX's trading hours. You can therefore enter and exit an investment in an ETF as you would a share, with a corresponding two day settlement period.

ETFs can help you diversify your portfolio across asset classes, sectors and geographies that otherwise could be difficult to access. For example, there are ETFs that cover emerging markets, specific market sectors, government and semi-government bonds, commodities and currencies.

ETFs are typically able to achieve lower operating costs and offer lower management fees (as measured by Management Expense Ratios or MERs) than other forms of professionally managed investments.

ETFs will change in value as the underlying asset or assets change in value. Depending on the type of product and the benchmark being tracked, investors can earn returns through price growth and/or distributions.

ETFs are designed to trade close to their underlying net asset value (NAV). This means that the market price should closely reflect the fair value of the ETF’s underlying assets.

Risks of investing in ETFs

There are risks associated with any investment. Generally, the higher the expected return of an investment, the higher the risk and the greater the variability of returns. You should consider how an investment in the ETF fits in your overall investment portfolio. ETFs have specific risks to make yourself aware of. When investing in an ETF that focuses on a specific asset class or style of investing, familiarise yourself with the risks particular to that investment. You should seek independent advice from a professional adviser before investing.

Market conditions (for example, a lack of liquidity in volatile markets) may make it difficult to buy or sell ETFs in certain circumstances.

At times the return of an ETF may deviate from the return of the index or benchmark attempting to be tracked.

Risk that a government or a regulator may introduce regulatory or tax changes which can affect the value of securities in which the ETF invests, the value of the ETF units or the tax treatment of the ETF.

Certain countries or regions may be subject to additional degrees of market volatility, economic and political instability. This may reduce or preclude the ability to trade securities or negatively impact a security’s value.

Currency risk is a consideration when investing globally. A weak Australian dollar will increase the value of investments held in non-Australian dollars. On the other hand, if the Australian dollar rises, the value of investments held in non-Australian dollars will fall; all other factors being equal.

The taxation for ETFs is different to shares. A distribution from an ETF represents your share of the income earned by the fund, which must be reported as income on your tax assessment. Taxation treatment may vary between asset classes. You should consult your taxation adviser for advice that takes into account your own financial circumstances.

ETFs that use derivatives to replicate an asset or index are subject to particular risks. Some ETFs for example may use some types of over the counter (OTC) derivatives that are not subject to central counterparty clearing arrangements and therefore have a higher exposure to counterparty risk.

ETFs may be susceptible to liquidity risk. Their liquidity will generally correlate to the liquidity in the market for the underlying asset or basket of assets - meaning that where the market for the underlying becomes illiquid, it is likely that the ETF product will also become illiquid.

Some ETFs may also carry additional risks, depending on the strategy they use or the assets they invest in. For example, some ETFs may use borrowing or leverage, which may increase risk. To understand fund-specific risks, read the ETF’s product disclosure statement and seek independent advice from a professional adviser before investing.

Specific risks for fixed income ETPs

There are a number of specific risks associated with investment in fixed income ETPs. These risks may result in different investment returns and a loss of income or capital value. Some of the risks include:

Interest rate movements: falling interest rates can lead to a decline in income for the ETP while rising interest rates can lead to a decline in the price or value of its assets.

Credit risk: the issuer of the underlying bonds within an ETP may fail to pay interest and principal or may have their credit rating downgraded and that can affect the value of the ETP.

Distributions risk: an ETP may not be able to pay a distribution because it has not received sufficient returns on its investments to do so.

Taxation risk: the taxation treatment of fixed income ETPs may be different to other asset classes such as shares.

Specific risks for Inverse ETPs

Inverse ETPs will generally seek to provide returns which are negatively correlated to an asset or index. An increase in the value of the asset or index will generally result in a decrease in the value of the product. A decrease in the value of the asset or index will generally result in an increase in the value of the product. This result is the opposite of most other ETPs.

These types of ETPs will typically use short selling or be constructed in a synthetic manner using OTC derivatives in order to obtain an inverse return. This makes these products riskier than many other ETPs. Short selling in particular may involve the risk of incurring substantial losses in excess of the initial amount invested. OTC derivatives may be subject to significant counterparty risk.

Specific risks for Leveraged ETPs

Leveraged ETPs generally involve the fund borrowing to gear its investment exposure or using OTC derivatives in order to obtain a geared return. This gearing not only magnifies the potential gains and losses from investing in the ETP; it also increases its volatility. These types of ETPs are therefore riskier than an equivalent product that does not provide a leveraged exposure.

An increase in the ETP’s cost of borrowing, which may result from an increase in interest rates generally or an increase in the specific borrowing rate charged by the lender, will likely reduce the product returns. Again, OTC derivatives may be subject to significant counterparty risk.

Specific risks for single asset ETPs

There are a number of additional specific risks associated with investments in single asset ETPs. These include:

Diversification: Holders of a single asset product don’t get the benefits of diversification that normally apply to an ETP which has exposure to a number of different assets.

Liquidity: Single asset products may be more susceptible to liquidity risk. Their liquidity will generally correlate to the liquidity in the market for the underlying asset - meaning that where the market for the underlying becomes illiquid, it is likely that the ETP product will also become illiquid.

Specific risks for synthetic ETPs

Synthetic ETPs, including most Structured Products, have different risks to other ETPs that investors should be aware of. You should always read the associated product disclosure statement carefully to ensure you understand how the product works and what risks it involves.

Synthetic ETPs use derivatives to achieve their investment objective. If you invest in these you are subject to the risk that the counterparty to the derivative may fail to meet some or all of their obligations. This risk is greater when the issuer uses over the counter (OTC) derivatives which are not subject to central counterparty clearing arrangements.

Specific risks for ETPs with internal market making arrangements

Some actively managed ETPs with concentrated equity portfolios are allowed to publish their portfolio composition periodically (eg quarterly) rather than daily as other ETPs do. This is to protect their proprietary trading strategies from having to be disclosed to the detriment of the ETP and investors in the ETP. These ETPs are required to publish an indicative net asset value (iNAV) that is updated frequently (usually every 15 minutes) so that investors have an idea of the value of the ETP’s portfolio of assets.

Typically these types of ETPs have internal market making arrangements where the ETP itself is responsible for providing liquidity in the ETP, rather than an external market maker. This creates potential conflicts and risks. As the profit from market making goes to the ETP, this creates an incentive for the ETP to widen spreads to produce additional returns for the ETP. In turn this means that investors may not be able to trade in and out of the ETP at prices as close to NAV as for other products.

Profits and losses from internal market making may also affect the performance of the ETP.