Benefits and risks
- Buy/sell flexibility: ETPs are traded on the ASX and this means that you can buy and sell during ASX's trading hours. You can therefore enter and exit an investment in an ETP as you would a share, with a corresponding two day settlement period.
- Diversification: ETPs can help you diversify your portfolio across markets or asset classes that otherwise could be difficult for you to access. For example, there are ETPs that cover emerging markets, specific market sectors, government and semi-government bonds, commodities and currencies.
- Lower cost: ETPs are typically able to achieve lower operating costs and the management fees (as measured by Management Expense Ratios or MERs) can be significantly lower than other forms of professionally managed investments.
- Returns from capital appreciation and income: ETPs will change in value as the underlying asset or assets change in value. Depending on the type of product and the benchmark being tracked, investors can earn returns through capital appreciation and/or distributions. Investors may also enhance after tax returns from franking credits.
- Fair value: ETPs are designed to trade close to their underlying net asset value (NAV). This means that the on-market price should closely reflect the fair value of the underlying assets of the ETP.
- Market risk: market conditions (for example, a lack of liquidity in volatile markets) may make it difficult to buy or sell ETPs in certain circumstances.
- Tracking performance: the return on an ETP may deviate from the return on the index or benchmark attempting to be tracked.
- Overseas investments: ETPs which seek to achieve the same return as a particular overseas market index or benchmark, and are traded and settled on ASX in Australian dollars, may be exposed to additional risks. If the ETP is not hedged against currency risk, fluctuations in the exchange rate can affect the value of the portfolio. Additionally, there may be political risks in the home country of the overseas market or benchmark which may also affect the value of the portfolio.
- Taxation outcomes: there may be different taxation treatment for gains and losses on synthetic ETPs when compared with direct replication ETPs that may significantly impact the effective return for investors.
- Use of derivatives and counterparty risk: ETPs that use derivatives to replicate an asset or index are subject to particular risks. Some ETPs for example may use over the counter (OTC) derivatives, which are not subject to central counterparty clearing arrangements and therefore have a higher exposure to counterparty risk.
There are a number of specific risks associated with investment in fixed income ETPs. These risks may result in different investment returns and a loss of income or capital value. Some of the risks include:
- Interest rate movements: falling interest rates can lead to a decline in income for the ETP while rising interest rates can lead to a decline in the price or value of its assets.
- Credit risk: the issuer of the underlying bonds within an ETP may fail to pay interest and principal or may have their credit rating downgraded and that can affect the value of the ETP.
- Distributions risk: an ETP may not be able to pay a distribution because it has not received sufficient returns on its investments to do so.
- Taxation risk: the taxation treatment of fixed income ETPs may be different to other asset classes such as shares.
Inverse ETPs will generally seek to provide returns which are negatively correlated to an asset or index. An increase in the value of the asset or index will generally result in a decrease in the value of the product. A decrease in the value of the asset or index will generally result in an increase in the value of the product. This result is the opposite of most other ETPs.
These types of ETPs will typically use short selling or be constructed in a synthetic manner using OTC derivatives in order to obtain an inverse return. This makes these products riskier than many other ETPs. Short selling in particular may involve the risk of incurring substantial losses in excess of the initial amount invested. OTC derivatives may be subject to significant counterparty risk.
Leveraged ETPs generally involve the fund borrowing to gear its investment exposure or using OTC derivatives in order to obtain a geared return. This gearing not only magnifies the potential gains and losses from investing in the ETP; it also increases its volatility. These types of ETPs are therefore riskier than an equivalent product that does not provide a leveraged exposure.
An increase in the ETP’s cost of borrowing, which may result from an increase in interest rates generally or an increase in the specific borrowing rate charged by the lender, will likely reduce the product returns. Again, OTC derivatives may be subject to significant counterparty risk.
There are a number of additional specific risks associated with investments in single asset ETPs. These include:
- Diversification: Holders of a single asset product don’t get the benefits of diversification that normally apply to an ETP which has exposure to a number of different assets.
- Liquidity: Single asset products may be more susceptible to liquidity risk. Their liquidity will generally correlate to the liquidity in the market for the underlying asset - meaning that where the market for the underlying becomes illiquid, it is likely that the ETP product will also become illiquid.
Synthetic ETPs, including most Structured Products, have different risks to other ETPs that investors should be aware of. You should always read the associated product disclosure statement carefully to ensure you understand how the product works and what risks it involves.
Synthetic ETPs use derivatives to achieve their investment objective. If you invest in these you are subject to the risk that the counterparty to the derivative may fail to meet some or all of their obligations. This risk is greater when the issuer uses over the counter (OTC) derivatives which are not subject to central counterparty clearing arrangements.
Some actively managed ETPs with concentrated equity portfolios are allowed to publish their portfolio composition periodically (eg quarterly) rather than daily as other ETPs do. This is to protect their proprietary trading strategies from having to be disclosed to the detriment of the ETP and investors in the ETP. These ETPs are required to publish an indicative net asset value (iNAV) that is updated frequently (usually every 15 minutes) so that investors have an idea of the value of the ETP’s portfolio of assets.
Typically these types of ETPs have internal market making arrangements where the ETP itself is responsible for providing liquidity in the ETP, rather than an external market maker. This creates potential conflicts and risks. As the profit from market making goes to the ETP, this creates an incentive for the ETP to widen spreads to produce additional returns for the ETP. In turn this means that investors may not be able to trade in and out of the ETP at prices as close to NAV as for other products.
Profits and losses from internal market making may also affect the performance of the ETP.