You will be able to name the main risks of an ETF and tell market risk from product risk.
When Nadia told her mother she was buying an ETF, her mother asked a fair question: "What happens if it goes bust?" Nadia started to say it couldn't, then stopped. She didn't actually know what could go wrong, or how badly.
An ETF is a simple product, but it isn't risk-free. The risks fall into two groups. Some come from what the fund holds, and you accept them the moment you buy. Others come from the fund itself, and you can reduce them by choosing carefully. Telling the two apart is most of the skill.
The biggest risk in a share ETF is the simplest. If the index falls, the fund falls with it. That's the deal. A fund built to follow an index will follow it down as faithfully as it follows it up.
This is not a fault in the fund. It's the risk you're paid to take, and it's the reason lesson 2.1 kept short-term money out of shares. A broad world fund might drop 30% in a bad year while doing exactly what it promised. No amount of fund selection removes market risk. The only things that change it 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 handful of companies grow very large, they can make up a big slice of the index, and your fund rises and falls largely with them.
Some indexes are concentrated by sector instead. The STI, for example, gives a large weight to banks and property-related companies, because those are among the biggest firms listed in Singapore. A fund on that index can hold 30 companies and still depend heavily on how one or two industries do.
Concentration isn't always bad, but you should know it's there. Open the fund's factsheet and look at the top ten holdings and the sector breakdown. If the top ten add up to a large part of the fund, or one sector dominates, the fund is less spread out than the number of holdings suggests.
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 those shares. Its SGD price moves with the shares and with exchange rates.
Here's a made-up example. Suppose the shares in a fund hold their value in US dollars over a year, but the US dollar falls 5% against the Singapore dollar. The same holdings are now worth about 5% less in SGD. Nadia would see her fund down roughly 5% even though nothing happened to the companies. The reverse can happen too, and a stronger US dollar would lift her SGD balance.
Currency moves tend to even out a little over long periods, but over a few years they can add or subtract a noticeable amount. Build and run an ETF portfolio looks at this properly in lesson 5.2, What currency moves do to your returns in SGD. For a first fund, simply know which currencies sit underneath it.
The last group belongs to the fund, not the market, and this is the one your mother's question was really about.
A fund can close. If an ETF doesn't attract enough money, its issuer may decide it isn't worth running and shut it down. You'd usually get cash back for your units at around their value, minus any costs, so the money doesn't vanish. But you'd be forced to sell at a time you didn't choose, pay a fresh commission to reinvest, and start your search again. 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 cause a gap between the index's return and the fund's. A small gap is normal. A wide or erratic one means you're not getting the index you paid for. The fund's factsheet shows its returns next to the index's, so you can see the gap over time. Build and run an ETF portfolio goes deeper on this in lesson 3.2, Tracking difference is what you actually lost to the index.
A third product risk applies to funds that use swaps with banks to deliver the index's return, as lesson 4.1 mentioned. They depend on the bank on the other side of the contract, and the fund's documents explain how that risk is limited. Most broad ETFs that buy the shares directly don't carry this risk.
Product risks are the ones you can reduce before you buy. Look for a fund with a decent size, a long enough history to judge, and a small, steady gap to its index. Market risk you accept, concentration and currency you understand, and product risk you check.
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.
For one ETF, write a sentence on each of the four risks and how much it applies to that fund.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).