They’ve only been around in Australia for a couple of years but they’re attracting plenty of small investors who are tired of the volatility of shares and the expensive fees and dull performance of most managed funds.
Their promoters make them sound simple, safe and easy to use. Are Exchange Traded Funds and Contracts for Difference really more frightening than you think?
Exchange traded funds
Exchange traded funds (ETFs) can be traded on the Australian Stock Exchange as shares.
Conventional ETFs aim to return the same amount or a similar sample as a benchmark or market index. They invest in the same securities that the benchmark has invested in, or at least a portion of them. Synthetic ETFs on the other hand, aim to replicate the returns of a benchmark index or market index by holding derivative products and an investor bank acting the counterparty.
Philip Gray of Morningstar said that the ETF market is still relatively young in Australia. This is in comparison to $330bn in managed funds.
Managed funds invest in a variety of assets, including Australian and international equity, fixed income, and property trusts. A single ETF trade is a great way for diversification.
ETF trading has the advantage that you pay a lower management cost than if you trade directly in managed funds.
“Investors have low-cost access to a range of investment classes, but they must have a clear investment strategy and do their research, to establish the risks they could face,” says Matthew Loughnan, head of retail at E*TRADE.
ETF trading is an efficient and tax-efficient way to invest. You can obtain franking credits and pay very little capital gains (CGT) tax. Portfolio turnover is less than managed funds.
Unlike equities, the market price at which ETFs trade normally mirrors their underlying value of the assets in the fund (known as the ‘net asset value’).
ETFs can be used by almost all investors. It depends on what kind of exposure you are looking for (e.g. Asian equities, gold), and whether there is an ETF that provides that.
“ETFs can be a useful tool for investors looking for long-term exposure or to make a short-term tactical decision across markets, commodities and currencies,” says an ASX spokesperson.
What you should know
Even if they do try, ETFs are not guaranteed to meet a benchmark.
Gray says ETFs will always incorporate the risk associated with the particular asset it invests in – such as the volatility of the equities market or the fluctuations in the commodity price.
Synthetic ETFs run the risk of not being able to hold the underlying physical securities. They are vulnerable to counterparty defaults, and non-payment ETF obligations.
There are differences between the tax rules for standard and synthetic ETFs, which can impact your returns.
These steps will help protect you if you decide you want to trade ETFs.
1. Understand what you’re buying. Learn how ETFs operate. Complex ETFs, which use derivatives and leverage to trade in risky assets or foreign market with less liquidity, will experience this double effect. So far, ETFs haven’t experienced a major market dislocation. They aren’t yet able predict how they’ll react to stress.
2. Avoid conflicts of interest. Banks often act as an ETF provider and derivatives counterparty in order to earn more fees. You can take over the ETF provider if it is unable to fulfill its obligations.
3. Check collateral. Check that collateral is not required for high-quality derivative positions.
4. Pay attention to currency fluctuations Some ETFs hedge currency risk, others don’t. And although the returns on some ETFs are tied to an overseas benchmark, such as the S&P 500, the trades would be settled in Australian dollars. If the ETF doesn’t provide currency risk hedge, it could impact the fund’s value. In other words, you’ll have an exchange rate risk.
5. Understanding ETF performance. How your ETF performs (particularly if it’s a synthetic ETF) may be very different from its underlying assets. An ETF might only invest in the largest stocks in an index to reduce costs.
Contracts for difference
Contracts for Difference (CFDs) are agreements between buyers and sellers to exchange the difference in security price. They can be opened at any time, but they must close at any other time.
If the security’s price rises, the seller will compensate the buyer for the difference.
Essentially, traders don’t own the security (which could range from options, currencies, to stock indices), but are rather concerned with the price.
When trading CFDs, you can either ‘go long’ or ‘go short’. To ‘go long’ implies you’re buying CFDs now because you expect the price of the security will increase, so that you can sell it later and make a profit. Doing the latter means you’re selling CFDs because you think the price will fall later and then you can buy it at a cheaper price.
CFD traders are more likely than investors to trade often. A position may be held up to four days.
CFDs not listed on the ASX may be traded. Some CFDs may be traded over the counter by a CFD broker. If you’re trading in the latter form, you need to read the provider’s terms and conditions. Exchange rate fluctuations can affect CFDs expressed in foreign currencies.
Big gains, big losses
It’s important to understand CFDs are a leveraged product, which means your profits or losses can greatly exceed the amount you initially invest.
Here are some examples: let’s say you wanted to go long and purchased 4,000 share CFDs in a company at $5 each (making the trade valued at $20,000). CFD providers advise that you have to put down a margin equal to 5%. So, you place $1,000 (0.05 x $20,000).
You would make $8,000 if your share price increased by $2. (4,000 x 2). Nice, huh?
However, if the share price falls by 2 dollars, you’ll need to invest $8,000. You can lose your investment in CFDs.
Peter Mathers of Trading Lounge states that CFDs don’t suit moms or dads.
“Although CFD trading can become a part of people’s portfolios, 95% of CFD traders tend to lose money,” says Mathers.
You shouldn’t enter the market without start-up money of about $50,000. This is required to cover brokerage commissions, which Mathers says can be around 20% of the trade’s value.
ETFs have the same risk as large contracts.
CFD providers might ask you to keep your trading account low in order to allow trade execution. If the market is against, this could prove very difficult.
Depending on which kind of CFD you’re trading, you will face the added risk of the underlying asset.
Trading CFDs in shares can affect your gains or losses in the equities market; currency CFDs expose traders to volatility in forex markets.
It is also important to understand the market in which your CFD trades.