Exchange-traded funds (ETFs) are a type of investment fund traded on stock exchanges. Generally, three types of ETFs are equity, bond, and commodity. Singapore investors may be familiar with global indices like MSCI World and emerging markets like Brazil’s Bovespa, primarily traded as ETFs or Index Funds.
The price they trade at is usually close to the Net Asset Value (NAV) of the assets that comprise it. They can also be traded intra-day throughout market hours, just like any other stock. Depending on the amount invested, some offer fixed units that guarantee shareholders a fixed return when redeeming them. Others do not have this feature.
Advantages of ETFs
ETFs are often seen as a cost-effective alternative to actively managed funds, which apply the fund manager’s discretion to pick securities for inclusion in the portfolio. Investors can use ETFs to diversify their portfolios, adding exposure where they see fit without directly buying baskets of different stocks or securities.
ETFs are popular investment instruments worldwide due to their low management fees and high transparency – transactions made on an ETF are usually extremely close to its underlying assets since it has to be formulated according to their stated policy (which outlines the basket composition).
This makes it possible for one ETF to mimic another, even with vastly different compositions. For example, SPDR S&P 500 ETF tracks the S&P 500 by investing in stocks representing the Index. This allows investors to gain exposure to large-cap US equities without scouting for individual blue-chip stocks.
Because ETFs track an index, it does not have an independent valuation since it simply reflects the underlying assets in the Index Fund. Therefore, its value may vary depending on how well or poorly the specific Index performs. Another helpful feature of ETFs is that they can be used as collateral for margin trading, opening another avenue for potential gains if the market moves in its favor.
Risks associated with ETFs
While ETFs may be attractive for some investors due to their accessibility and cost benefits over active funds, they can come with risks that should be considered before investing.
ETFs are typically traded on an exchange, which means they can be subject to higher intraday volatility than open-end funds, where units are redeemed or repurchased at the end of each trading day.
The price of ETF shares is determined by the market price of fund units, not their net asset value (NAV), meaning investors may sell units for more or less than it is worth. ETFs should thus not be considered as fixed income securities or cash equivalents, and there is no assurance that the investment will preserve or maintain its value in periods of financial stress.
For instance, if markets experience a significant correction resulting in significant sell-offs across key markets, this could lead to the rapid liquidation of ETF units, which may cause their market prices to diverge significantly from their net asset values.
Furthermore, certain types of ETFs have a higher tracking error risk than others. For example, leveraged and inverse exchange-traded funds seek to achieve returns 2x or -2x the recovery of their Index daily, but they do so at the expense of high tracking errors. If an investor holds a leveraged S&P 500 fund for three months instead of one day, he may receive less than twice or double the return.
As such, an investment in these types of products should only be made by investors who understand the risks involved and are willing to accept significant tracking errors in return for potentially high returns over a short period.
Summary
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