New York, New York (PressExposure) July 25, 2011 -- http://www.telegraph.co.uk/finance/personalfinance/investing/8582376/Ten-tips-to-safely-invest-in-ETFs.html
How can you tell if an exchange -traded fund is safe? Here are 10 tips for investors considering ETFs.
Look for the UCITS label
Any fund which complies with EU undertakings for collective investment in transferable securities (UCITS) statutes will be subject to investor protection rules, such as compulsory diversification to reduce risk. For example, no more than 5pc of these ETFs can be invested in any one share and no more than 10pc can be invested in unapproved securities.
Beware exchange-traded products
ETPs are often loosely described as ETFs but no ETP qualifies for UCITS, so may hold assets which are difficult to turn back into cash in a hurry. Where's the beef?
Physical ETFs hold the assets on which they are based and so are less risky than synthetic ETFs which rely on financial derivatives. Ben Yearsley of Hargreaves Lansdown said: "The only ones I would consider holding are physically backed ETFs which actually own the underlying commodity. They do a far better job of tracking the underlying price than a derivative-backed ETF. Second, a derivative backed ETF doesn't reduce risk as there will be a counterparty involved."
No guarantee is worth any more than the guarantor
Counterparty risk is City jargon for the danger that companies backing synthetic ETFs may fail to deliver.
Past performance is no guarantee of future returns
However, it is well worth considering. John Fletcher, of Charles Stanley stockbrokers, said: "Tracking error - that is, the degree to which the ETF price varies from the index or commodity it follows - can vary greatly between similar ETFs and this needs to be researched."
Don't get caught short
ETFs that aim to profit from falling prices can produce surprising results. Ben Gutteridge, a director of wealth managers Brewin Dolphin, explained: "Most are based on daily closing prices. This means a 10pc rise one day will lead to a 10pc fall in your short ETF. If we carry this on for a five-day pattern, a £100 long investment would be worth approximately £161 - that is, up 61pc. But, such is the mechanics of daily calculation that a £100 investment in a short ETF will be worth £62 - that is, down 38pc. This imperfect hedge needs to be accounted for. Also, the more volatile the referenced asset, the greater this imperfection risk becomes."
Big may be beautiful
Mr Fletcher said: "One indicator of whether to invest or not is the level of assets under management (AUM) within the ETF - a low AUM may eventually result in a delisting. So we lean toward the larger funds."
Leverage is a two-edged sword
Borrowing to invest - called "leveragee_SDRq - can increase losses as well as profits.
Synthetic commodity ETFs can deliver a nasty surprise
Mr Gutteridge pointed out: "Unless purchasing an ETF that holds the physical commodity, investors are at the mercy of not only of the spot price but interest rates and a phenomenon known as 'roll yield'.
"In order not to receive delivery of the underlying commodity, ETFs will sell the expiring contract - known as a 'future' - and buy back into one with a longer maturity. This is not a like-for-like transaction, however, as longer maturities are usually more expensive. Each time a contract is rolled in this way, the ETF will suffer. Using financial parlance, contango is a rising futures curve with a negative roll yield and backwardation is a falling futures curve with a positive roll yield."
If in doubt, do now. Avoid investments that baffle you. They might bite.