Exchange Traded Funds (ETFs) have grown in their popularity in recent years, but a new warning reminds investors that some ETFs are riskier than others.
ETFs differ in their index replication strategies.
Some, which we prefer, use full replication and therefore physically hold the underlying basket of shares for the index they seek to replicate.
Others introduce counterparty risk by investing a smaller amount in the index and the balance in other holdings, such as futures, options and swap contracts, in order to replicate the index return.
In this respect, some ETFs are more like structured products with all of the risks these introduce for the investor.
There are other important issues to consider, such as the stock lending policy of the ETF, how index returns are calculated and the taxation of returns.
Within their warning, which was technically aimed at Exchanged Traded Products (ETPs) but applies equally to Exchange Traded Funds, the FSA made the important point that these products and their risks need to be fully understood before an investment is made.
ETFs can play an important role in a well diversified investment portfolios, as long as they are properly understood and the risk factors of using these instruments are fully quantified.
Photo credit: Flickr/Katrina.Tuliao
