Dr Wise: Not all exchange-traded funds track market performance directly

27 Jul 2010

More and more exchange-traded funds (ETFs) adopt a synthetic replication strategy so it is unwise to invest in them without fully understanding how they work behind the scene.

In his latest column entitled “Synthetic Exchange-traded Funds: What Does it Do for You?” Dr Wise reminds investors to look carefully at the “synthetic” nature of ETFs.

For reasons such as access to a restricted market, greater efficiency or cost savings, synthetic ETFs using a synthetic replication strategy invest in over-the-counter derivatives issued by counterparties to gain exposure to the underlying indices. Investors of synthetic ETFs are, therefore, exposed to the credit risk of the counterparties who issued the derivatives, in addition to the risks of the shares or bonds the ETFs synthetically replicate.

Some synthetic ETFs diversify the credit risk of counterparties by acquiring financial derivatives from many counterparties. However, the more counterparties an ETF has, the higher the mathematical probability of the ETF being affected by a counterparty default. Other ETFs only acquire financial derivatives from a few counterparties and require each of them to pledge collateral to reduce the ETFs’ net exposure counterparty risk. In the latter case, the investor’s counterparty risk exposure is limited to the value not covered by the collateral. However, although ETF managers monitor the collateral closely, there is always a risk that its market value is reduced substantially.

“Some investments are not as straightforward as you think,” says Dr Wise. “Until you thoroughly understand the setup of an investment product, do not make a commitment.”

Information about an ETF’s counterparties and collateral is available from its offering document, which can be downloaded from the websites of Hong Kong Exchanges and Clearing Ltd and the ETF issuers.

Through his column, Dr Wise, a fictitious character created by the Securities and Futures Commission (SFC), shares with the public his wisdom on investing and his thoughts on regulatory issues.

Dr Wise’s column is published on the last working Tuesday of every month. The column is posted under the “Dr Wise” section of the SFC’s InvestEd website. Investors are welcome to send their feedback and questions to Dr Wise by email to InvestEd@sfc.hk.

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Page last updated : 1 Aug 2012