Understanding Risks of ETFs 
14/02/2017 
 

This education document is intended as a general guide to highlight some basic facts and characteristics of certain types of securities.  HKEX and/or its subsidiaries endeavor to ensure the accuracy and reliability of the information provided, but does not guarantee its accuracy and accepts no liability (whether in tort or contract or otherwise) for any loss or damage arising from any inaccuracies or omissions. If investors require further information for investing in securities, they should refer to the prospectuses and other documents issued by the issuers on the HKEXnews website (http://www.hkexnews.hk) and consult their brokers or other professional advisors prior to making any decision.

Some Risks Associated with Exchange Traded Funds (ETFs)
 
1. 

Market risk 
 
ETFs are typically designed to track the performance of certain indices, market sectors, or groups of assets such as stocks, bonds, or commodities.  ETF managers may use different strategies to achieve this goal, but in general they do not have the discretion to take defensive positions in declining markets.  Investors must be prepared to bear the risk of loss and volatility associated with the underlying index/assets.
 

2.

Tracking errors 
 
Tracking errors refer to the disparity in performance between an ETF and its underlying index/assets.  Tracking errors can arise due to factors such as the impact of transaction fees and expenses incurred to the ETF, changes in composition of the underlying index/assets, and the ETF manager’s replication strategy.  (The common replication strategies include full replication/representative sampling and synthetic replication which are discussed in more detail below.)
 

3.

Trading at discount or premium
 
An ETF may be traded at a discount or premium to its Net Asset Value (NAV).  This price discrepancy is caused by supply and demand factors, and may be particularly likely to emerge during periods of high market volatility and uncertainty.  This phenomenon may also be observed for ETFs tracking specific markets or sectors that are subject to direct investment restrictions.
 

4.

Foreign exchange risk 
 
Investors trading ETFs with underlying assets not denominated in Hong Kong dollars are also exposed to exchange rate risk.  Currency rate fluctuations can adversely affect the underlying asset value, also affecting the ETF price.
 

5.

Liquidity risk 
 
Securities Market Makers (SMMs) are Exchange Participants that provide liquidity to facilitate trading in ETFs.  Although most ETFs are supported by one or more SMMs, there is no assurance that active trading will be maintained.  In the event that the SMMs default or cease to fulfill their role, investors may not be able to buy or sell the product.
 

6. Counterparty risk involved in ETFs with different replication strategies
 
(a)

Full replication and representative sampling strategies
 
An ETF using a full replication strategy generally aims to invest in all constituent stocks/assets in the same weightings as its benchmark.  ETFs adopting a representative sampling strategy will invest in some, but not all of the relevant constituent stocks/assets.  For ETFs that invest directly in the underlying assets rather than through synthetic instruments issued by third parties, counterparty risk tends to be less of concern.
 

(b)

Synthetic replication strategies
 
ETFs utilising a synthetic replication strategy use swaps or other derivative instruments to gain exposure to a benchmark.  Currently, synthetic replication ETFs can be further categorized into two forms:
 

i.

Swap-based ETFs

  • Total return swaps allow ETF managers to replicate the benchmark performance of ETFs without purchasing the underlying assets.
     
  • Swap-based ETFs are exposed to counterparty risk of the swap dealers and may suffer losses if such dealers default or fail to honor their contractual commitments.
     
ii.

Derivative embedded ETFs

  • ETF managers may also use other derivative instruments to synthetically replicate the economic benefit of the relevant benchmark.  The derivative instruments may be issued by one or multiple issuers.
     
  • Derivative embedded ETFs are subject to counterparty risk of the derivative instruments’ issuers and may suffer losses if such issuers default or fail to honour their contractual commitments.
     

Even where collateral is obtained by an ETF, it is subject to the collateral provider fulfilling its obligations.  There is a further risk that when the right against the collateral is exercised, the market value of the collateral could be substantially less than the amount secured resulting in significant loss to the ETF.

It is important that investors understand and critically assess the implications arising due to different ETF structures and characteristics.  Click here to see the summary classification of the currently listed ETFs on the HKEX securities market.
    

For more information on ETFs, please visit the Products & Services section of the HKEX corporate website: http://www.hkex.com.hk/eng/prod/secprod/etf/etfmain.htm


Additional information on ETFs can also be found on the SFC website:

ETF Leaflet

Index Tracking Exchange Traded Fund