Wednesday, February 17, 2010

Concerns on ETFs

I love ETFs. They allow retail investors to invest in indices with low costs, liquidity, give dividends and even have a helpline that you can call everyday to ask about the ETF you bought. What else can we ask for? However, due to time constraint and limited resources, I haven't been able to research and answer some thorny questions on them. If anybody reading this have answers, pls do comment and share the knowledge.

1. Forex risk

Most ETFs on the SGX are listed in USD and as we know, the USD is being dragged to hell as Fed prints money like there is no tomorrow to save the economy. Albeit this process will take many many years. However, if our ETF is in USD, wouldn't that mean that we are being screwed? My answer would be no. Bcos the USD is just a medium to reflect the underlying securities. What matters is the underlying intrinsic value of the securities, not the medium. Take oil for example, it is also in USD. But the underlying value of oil will continue to grow because there is not much left. So USD goes down by 20%, doesn't mean oil price will go down by 20%. Am I right?

2. Counterparty risks

What if the issuer of the ETF goes down? Like Lehman. What would happen to the ETF? My understanding is that since the ETF would be held by CDP and we do own the underlying stocks with the ETF, it can be liquidated and the money goes back to us. But is that good enough? How about if the issuer decides to close the ETF bcos it's no longer popular, or whatever other reasons they might have, are they obligated to give us money back at a fair value? Say the NAV of the ETF, of which the NAV is thoroughly calculated to reflect the real NAV of the index?

3. Swap based ETFs

Some ETFs do not actually own the underlying stocks of the index they are suppose to represent but a completely different basket of stocks and the return of that basket is swapped for the return of the index. This goes for most Lyxor ETFs. So when we buy the Lyxor China ETF, we actually own a lot of European stocks, whose returns are being swapped for the return of the Hang Seng China Index. So what are the risks involved here? One obvious one would be again counterparty risk. If the swap counterparty cannot honour the agreement, then ultimately we get screwed. Say the European stocks collapsed 20% while HSCEI was up 20%. The counterparty cannot deliver, the ETF holders might get short-changed. What about other risks? I don't have all answers though.

Here are just 3 issues, but I think there are many others that we have not thought about. If anybody has any answers, pls do share, thanks!
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