Name the main risks of an ETF and tell market risk apart from product risk.
Open the factsheet for one ETF you are thinking of buying and keep it beside you while you read. At the end you will rate that fund against four risks, and the factsheet holds most of what you need to do it.
Nadia told her mother she was buying an ETF. Her mother asked what would happen if it went bust. Nadia started to say it couldn't, then stopped, because she didn't actually know what could go wrong with the fund or how badly. An ETF is a simple product, but it is not risk-free.
ETF risks fall into two groups, and telling them apart is most of the skill. Risks from what the fund holds come with the purchase, and you accept them the moment you buy. Risks from the fund itself can be reduced by choosing carefully. Market, concentration and currency risk belong to the first group. Product risk belongs to the second. The rule to keep: market risk you accept, concentration and currency risk you understand, product risk you check.
Market risk is the fund falling when the index it follows falls. In a share ETF it is the biggest risk and the simplest. The fund follows the index down as faithfully as it follows it up, so a fall is not a fault in the fund. It is the risk you are paid to take, and it is the reason lesson 2.1 kept short-term money out of shares.
A broad world fund might drop 30% in a bad year (an illustrative figure) while doing exactly what it promised. No choice of fund removes market risk. The only things that change how much of it you carry are how much of your money is in shares and how long you can wait.
Lesson 4.1, An ETF is a basket that follows an index, showed that most indexes weight companies by size. When a few companies grow very large, they can form a big slice of the index, and the fund then moves largely with them. That dependence on a few companies, or on one or two sectors, is concentration risk.
Some indexes are concentrated by sector rather than by company. The STI gives a large weight to banks and property-related companies, because those are among the biggest firms listed in Singapore. A fund on the STI can hold 30 companies and still depend heavily on one or two industries. Concentration is not always bad, but you should know it is there. To check, look at the top ten holdings on the factsheet, then the sector breakdown. If the top ten make up a large part of the fund, or one sector dominates, the fund is less spread out than its number of holdings suggests.
Currency risk comes from how the holdings are priced. Most of the world's large companies are priced in US dollars, euros, yen and other currencies. A world ETF bought on SGX in Singapore dollars still holds shares priced in those currencies, so its SGD price moves with exchange rates as well as share prices. A weaker US dollar against SGD lowers the SGD value of US holdings, and a stronger US dollar raises it.
Suppose the shares hold their value in US dollars over a year but the US dollar falls 5% against the Singapore dollar (an invented example). The holdings are worth about 5% less in SGD, and Nadia sees her fund down roughly 5% with nothing having happened to the companies. Had the US dollar strengthened, her SGD balance would have risen. These moves tend to even out a little over long periods, but over a few years they can add or subtract a noticeable amount. For a first fund, you only need to know which currencies sit underneath it. Lesson 5.2 of the course Build and run an ETF portfolio, What currency moves do to your returns in SGD, covers currency risk properly.
Product risk comes from the fund itself, and it is what Nadia's mother was really asking about. It has three parts: closure, poor tracking and, for some funds, dependence on a bank.
A fund can close if it doesn't attract enough money and the issuer decides it isn't worth running. Investors usually get cash back for their units at around their value minus any costs, so the money does not vanish. The costs are a forced sale at a time you didn't choose, a fresh commission to reinvest, and restarting your fund search. Small funds close more often than large ones.
A fund can also track its index poorly. Costs, cash held in the fund, sampling and trading all create a gap between the index return and the fund return. A small gap is normal; a wide or erratic gap means you are not getting the index you paid for. The factsheet shows fund returns next to index returns, so you can watch the gap over time and look for one that is small and steady. Lesson 3.2 of Build and run an ETF portfolio, Tracking difference is what you actually lost to the index, goes deeper on this.
A swap-based fund uses contracts with banks to deliver the index return instead of buying the shares directly. Lesson 4.1 mentioned these. Such a fund depends on the bank on the other side of the contract, and its documents explain how that counterparty risk is limited. Most broad ETFs that buy the shares directly do not carry this risk.
Product risks are the ones you can reduce before buying. Check that the fund is a decent size, that it has a long enough history to judge, and that its gap to the index is small and steady. For a swap-based fund, also read how its documents limit counterparty risk.
Choose one ETF you might buy and keep its factsheet open. For each of the four risks, decide how much it applies to that particular fund, high, medium or low, and why.
Pick one ETF. For each of the four risks, write one sentence on how much it applies to that fund.
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