INVESTOR
EDUCATION
INVESTOR
EDUCATION
EXCHANGE
TRADED FUNDS(ETFS)
Exchange Traded Funds (ETFs) are a rapidly growing investment product that has gained popularity worldwide. The number of ETFs listed on the HKEx (Hong Kong Exchange) currently stands over 170, and this number continues to increase.
Definition of ETFs
ETFs are open-end index funds that are listed and traded on exchanges similar to stocks. They can be bought and sold during regular trading hours through any broker on most trading platforms. Like index funds, ETFs consist of a collection of securities that are designed to track specific indexes.
Benefits of Using ETFs
1. Diversification
ETFs inherently provide diversification as they track indices comprising a variety of securities. By investing in ETFs, you can gain exposure to entire countries or sectors while reducing risk associated with individual stocks.
2. Low Cost
Compared to comparable index or active mutual funds, ETFs often have lower fees and expense ratios. When trading ETFs, you only need to pay standard brokerage commissions and fees.
3. Liquidity
ETFs offer high liquidity, similar to the underlying basket of securities represented by their respective indexes. When the demand for an ETF increases in the secondary market, new shares are created and introduced into the market.
4. Transparency
ETFs generally provide transparency by disclosing the exact holdings of the fund on a regular basis, often daily. This means you always have up-to-date information about the securities in which you are invested. Additionally, ETFs offer cost transparency through upfront fee disclosure, ensuring that you are aware of the expenses associated with the investment.
Types of Exchange-Traded Funds (ETFs)
1. Cash-based ETFs:
– These ETFs hold the underlying securities of the index they track.
– They typically employ a full replication strategy, where they hold all securities within the index.
– In some cases, representative sampling or optimization strategies are used, where only a portion of the underlying securities are held.
2. Swap-based ETFs:
– Swap-based ETFs replicate the performance of an index using total return index swaps.
– They can provide exposure to markets that are not accessible through cash-based funds, such as commodities.
– However, there is some exposure to counterparty risk associated with swap-based ETFs.
Risks of Investing in ETFs
Investing in ETFs carries certain risks, which investors should carefully consider. The following risks are associated with ETF investments:
1. Market Risk:
– ETF prices, like stocks, are subject to fluctuation due to various factors.
– Investors should be aware of the possibility of market volatility and its potential impact on ETF prices.
2. Tracking Error:
– Since ETFs are designed to replicate an index or benchmark, there is a chance that the returns earned by the ETF may differ from the index.
– This divergence, known as tracking error, can be positive (profitable) or negative (returns less than indicated by the index).
3. Foreign Exchange Risk:
– ETFs that invest in assets denominated in foreign currencies are exposed to currency rate fluctuations.
– Fluctuations in currency exchange rates can affect the value of the ETF’s underlying assets and consequently impact the price of ETF shares.
Introduction of leveraged and inverse products
Leveraged and inverse products, also known as L&I Products, are structured as funds and fall under the category of derivative products. However, unlike traditional index tracking exchange traded funds (ETFs), L&I Products have a different approach. These products aim to provide a multiple or opposite return of the underlying index on a daily basis only. Leveraged products seek to achieve a daily return equivalent to a multiple of the index return. This means that if an investor purchases a two-time leveraged product, and the underlying index increases by 10% in a day, the product should deliver a gain of 20% on that day. On the other hand, inverse products aim to deliver the opposite daily return of the underlying index. For instance, when an investor buys a one-time inverse product and the underlying index moves up by 10% on a given day, the inverse product should deliver a loss of 10% on that day.
Major risks of leveraged and inverse products
Investment risk
The risk investment results of products are the opposite of traditional investment funds. If the product moves in an unfavorable direction, the product you invest in is likely to lose most or all of its value.
Leverage risk
The use of leverage will magnify both gains and losses of leveraged products resulting from changes in the underlying index or, where the underlying index is denominated in a currency other than the leveraged product’s base currency, from fluctuations in exchange rates.
Passive investments risks
The Product is not “actively managed” and therefore the Manager will not have discretion to adapt to market changes when the Index moves in an unfavorable direction to the Product. In such circumstances the Product will also decrease in value.
Tracking error
Due to fees, expenses, transaction costs as well as costs of using financial derivatives, liquidity of the market and the investment strategy adopted by the Manager, the correlation between the performance of the Product and the Daily inverse performance of the Index may reduce.
Liquidity risk
Rebalancing typically takes place near the end of a trading day (shortly before the close of the underlying market) to minimize tracking difference. The short interval of rebalancing may expose L&I Products more to market volatility and higher liquidity risk.
Long-term holding risk
Leveraged and inverse products are not intended for holding longer than the rebalancing interval, typically one day. Daily rebalancing and the compounding effect will make the L&I Product’s performance over a period longer than one day deviate in amount and possibly direction from the leveraged/inverse performance of the underlying index over the same period. The deviation becomes more pronounced in a volatile market.
As a result of daily rebalancing, the underlying index’s volatility and the effects of compounding of each day’s return over time, it is possible that the leveraged product will lose money over time while the underlying index increases or is flat. Likewise, it is possible that the inverse product will lose money over time while the underlying index decreases or is flat.
Risk of rebalancing activities
There is no assurance that L&I Products can rebalance their portfolios on a daily basis to achieve their investment objectives. Market disruption, regulatory restrictions or extreme market volatility may adversely affect the rebalancing activities.
Portfolio turnover risk
Daily rebalancing causes a higher levels of portfolio transaction when compared to conventional ETFs, and thus increases brokerage and other transaction costs.
Correlation risk
Fees, expenses, transactions cost as well as costs of using financial derivatives may reduce the correlation between the performance of the L&I Product and the leveraged/inverse performance of the underlying index on a daily basis.
For the basic knowledge and trading mechanism of Exchange Traded Funds (ETF), please refer to the information provided by Investor and Financial Education Council. You should pay careful attention to the Liability Statement section on the homepage of the website of The IFEC at (www.ifec.org.hk) when referring to information using this link.
Exchange
Traded Funds (ETFs)
Exchange Traded Funds (ETFs) are a rapidly growing investment product that has gained popularity worldwide. The number of ETFs listed on the HKEx (Hong Kong Exchange) currently stands over 170, and this number continues to increase.
Definition of ETFs
ETFs are open-end index funds that are listed and traded on exchanges similar to stocks. They can be bought and sold during regular trading hours through any broker on most trading platforms. Like index funds, ETFs consist of a collection of securities that are designed to track specific indexes.
Benefits of Using ETFs
1. Diversification
ETFs inherently provide diversification as they track indices comprising a variety of securities. By investing in ETFs, you can gain exposure to entire countries or sectors while reducing risk associated with individual stocks.
2. Low Cost
Compared to comparable index or active mutual funds, ETFs often have lower fees and expense ratios. When trading ETFs, you only need to pay standard brokerage commissions and fees.
3. Liquidity
ETFs offer high liquidity, similar to the underlying basket of securities represented by their respective indexes. When the demand for an ETF increases in the secondary market, new shares are created and introduced into the market.
4. Transparency
ETFs generally provide transparency by disclosing the exact holdings of the fund on a regular basis, often daily. This means you always have up-to-date information about the securities in which you are invested. Additionally, ETFs offer cost transparency through upfront fee disclosure, ensuring that you are aware of the expenses associated with the investment.
Types of Exchange-Traded Funds (ETFs)
1. Cash-based ETFs:
– These ETFs hold the underlying securities of the index they track.
– They typically employ a full replication strategy, where they hold all securities within the index.
– In some cases, representative sampling or optimization strategies are used, where only a portion of the underlying securities are held.
2. Swap-based ETFs:
– Swap-based ETFs replicate the performance of an index using total return index swaps.
– They can provide exposure to markets that are not accessible through cash-based funds, such as commodities.
– However, there is some exposure to counterparty risk associated with swap-based ETFs.
Risks of Investing in ETFs
Investing in ETFs carries certain risks, which investors should carefully consider. The following risks are associated with ETF investments:
1. Market Risk:
– ETF prices, like stocks, are subject to fluctuation due to various factors.
– Investors should be aware of the possibility of market volatility and its potential impact on ETF prices.
2. Tracking Error:
– Since ETFs are designed to replicate an index or benchmark, there is a chance that the returns earned by the ETF may differ from the index.
– This divergence, known as tracking error, can be positive (profitable) or negative (returns less than indicated by the index).
3. Foreign Exchange Risk:
– ETFs that invest in assets denominated in foreign currencies are exposed to currency rate fluctuations.
– Fluctuations in currency exchange rates can affect the value of the ETF’s underlying assets and consequently impact the price of ETF shares.
Introduction of leveraged and inverse products
Leveraged and inverse products, also known as L&I Products, are structured as funds and fall under the category of derivative products. However, unlike traditional index tracking exchange traded funds (ETFs), L&I Products have a different approach. These products aim to provide a multiple or opposite return of the underlying index on a daily basis only. Leveraged products seek to achieve a daily return equivalent to a multiple of the index return. This means that if an investor purchases a two-time leveraged product, and the underlying index increases by 10% in a day, the product should deliver a gain of 20% on that day. On the other hand, inverse products aim to deliver the opposite daily return of the underlying index. For instance, when an investor buys a one-time inverse product and the underlying index moves up by 10% on a given day, the inverse product should deliver a loss of 10% on that day.
Major risks of leveraged and inverse products
Investment risk
The risk investment results of products are the opposite of traditional investment funds. If the product moves in an unfavorable direction, the product you invest in is likely to lose most or all of its value.
Leverage risk
The use of leverage will magnify both gains and losses of leveraged products resulting from changes in the underlying index or, where the underlying index is denominated in a currency other than the leveraged product’s base currency, from fluctuations in exchange rates.
Passive investments risks
The Product is not “actively managed” and therefore the Manager will not have discretion to adapt to market changes when the Index moves in an unfavorable direction to the Product. In such circumstances the Product will also decrease in value.
Tracking error
Due to fees, expenses, transaction costs as well as costs of using financial derivatives, liquidity of the market and the investment strategy adopted by the Manager, the correlation between the performance of the Product and the Daily inverse performance of the Index may reduce.
Liquidity risk
Rebalancing typically takes place near the end of a trading day (shortly before the close of the underlying market) to minimize tracking difference. The short interval of rebalancing may expose L&I Products more to market volatility and higher liquidity risk.
Long-term holding risk
Leveraged and inverse products are not intended for holding longer than the rebalancing interval, typically one day. Daily rebalancing and the compounding effect will make the L&I Product’s performance over a period longer than one day deviate in amount and possibly direction from the leveraged/inverse performance of the underlying index over the same period. The deviation becomes more pronounced in a volatile market.
As a result of daily rebalancing, the underlying index’s volatility and the effects of compounding of each day’s return over time, it is possible that the leveraged product will lose money over time while the underlying index increases or is flat. Likewise, it is possible that the inverse product will lose money over time while the underlying index decreases or is flat.
Risk of rebalancing activities
There is no assurance that L&I Products can rebalance their portfolios on a daily basis to achieve their investment objectives. Market disruption, regulatory restrictions or extreme market volatility may adversely affect the rebalancing activities.
Portfolio turnover risk
Daily rebalancing causes a higher levels of portfolio transaction when compared to conventional ETFs, and thus increases brokerage and other transaction costs.
Correlation risk
Fees, expenses, transactions cost as well as costs of using financial derivatives may reduce the correlation between the performance of the L&I Product and the leveraged/inverse performance of the underlying index on a daily basis.
For the basic knowledge and trading mechanism of Exchange Traded Funds (ETF), please refer to the information provided by Investor and Financial Education Council. You should pay careful attention to the Liability Statement section on the homepage of the website of The IFEC at (www.ifec.org.hk) when referring to information using this link.
