Exchange traded funds (ETFs) are low cost, open-ended investment trusts listed and traded on a stock exchange with the aim to track, replicate or correspond to the performance to the underlying index or asset classes. It can be sold short, leveraged with margin, hedged with call/put options or bought and held. There are two structures of ETFs which are cash-based ETFs and synthetic ETFs. Cash-based ETFs are ETFs that invest directly into the assets that make up the index such as stocks, bond or assets. However, synthetic ETFs that use derivative products such as swaps or access products (for example, participatory notes) to produce returns which track the relevant indices.
The appeal of investing in ETFs would be ETFs are very liquid and can be traded throughout the day unlike mutual funds, its net asset value (NAV) is being quoted at the end of the trading day which is a crucial differentiating factor to exit a losing investment in order to preserve limited capital. ETFs also provide access to a wide variety of markets and asset classes such as stocks, bonds, currencies, real estate and commodities that will give a diversified portfolio of all sectors which will help to diversify unsystematic risk and gain market exposure easily.
The benefits of investing in ETFs will be passive management, cost-efficiency and tax-efficiency. Since the purpose of an ETF is to match a particular market index and not to outperform the market, it gives rise to a fund management style called passive management. The feature of passive management of ETFs means the fund manager makes only minimal, occasional changes to keep the fund in line with its index. Due to passive management of ETFs, it lessen the element of ‘managerial risk’ because fund managers doesn’t need to constantly buy and sell securities. Therefore, ETFs can be considered a safe investment. As a result, there will be fewer taxable distributions, and a more efficient overall return on investment because securities in ETFs are not frequently traded. In addition, it is much more cost-efficient than investing in unit trusts as ETFs are bought through brokers instead of buying directly from the fund which saves the cost of marketing it to retail investors. Thus, sales charges is not imposed on ETFs which translates into lower management fees (Appendix F) and they don’t usually carry high sales load which means there are fewer recurring costs to reduce your returns which causes it to be more cost-efficient and tax-efficient.
However, there are also disadvantages investing in ETFs such as index risk, tracking error and liquidity risk. Even though ETFs are passively managed which mitigate the element of ‘managerial risk’, it faces index risk because of the purpose to match the performance of an index. Thus, the fund manager will not sell the security if the security’s issuer is in financial difficulties and will not increase exposure to securities that are anticipated to increase in value which will result in a loss and deprivation of opportunities to earn higher return from investing in ETFs. The second risk faced will be tracking error. Tracking error occurs when the ETF does not match the performance of the index and represents the difference between the return of the ETF and the underlying index. It could happen due to the expenses incurred that an index does not have when it conducts a purchase or sale of securities and the frequency of these transactions occurrence could increase the cost which will increase tracking error and diminish an ETF performance. The last risk will be liquidity risk. Since ETFs are traded throughout the day which is similar to stocks, investors who are interested in the particular ETFs will purchase or sell at a wide ranging prices which can be seen with continuous bid-offer prices. However, if there is a lack of liquidity for the ETFs, it could lead to wide bid-offer spread which cause the ETF to trade at a large premium or discount to Net Asset Value. It means that the investor could be overpaying for the ETF or the investor could get less than the basket of securities worth.
Despite all the risks involved, ETFs will be a suitable investment for Joe to consider to add on because it doesn’t require him to actively manage his investment portfolio but it will be managed by a fund manager through the matching of index rather than active trading which might cause him to incur losses through the sale of securities. Furthermore, it is widely diversified through different sectors which will help to minimise the loss as compared to investing in stocks which is only concentrated in one sector. Lastly, ETFs are also affordable as it doesn’t impose sales charges as compared to unit trusts and only a minimal management fees are imposed and the brokerage fees. Therefore, ETFs is a recommended financial instrument for his investment portfolio which will help him to earn returns to fund his degree course at Australia in six years’ time but it is cash-based ETFs and not synthetic ETFs due to the risk involved.
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