Individual Investors

How to Pick the Right ETF? Part 2

View Part 1 | Investment Strategy

Part 2 | Risks and weaknesses

Exchange traded funds have earned a justified reputation as being among the safest types of funds. However, ETFs are not perfect. There are risks and weaknesses that investors should know.

Some ETFs lend out their shares to short-sellers

Some ETFs lend out the shares that they hold to short sellers. Short-sellers borrow shares and sell them, with a view to buying them back later (at a lower price) and returning them to the borrower. Short sellers pay rental fees for what they have borrowed to the ETF issuer.

The rental fees are usually very small, as the lending market is competitive and dominated by large industry superannuation funds. Rental fees are then shared with the custodian or agent, which shrinks them further.

Lending shares to short sellers is risky as what is borrowed may never be returned. Investors should always ask about securities lending.

Some ETFs are feeder funds that buy US-domiciled ETFs

Some ETFs that invest in global shares are not locally domiciled ETFs at all. Instead, they are feeder funds that buy into US-domiciled ETFs. Some emerging market ETFs are examples of this. These feeder funds have the advantages of coming at a low cost, as they are cheaper for ETF providers to make.

However, they can have tax weaknesses. Any fund domiciled in the US must pay US taxes, on top of the taxes in the target investment destination. For example, Australians buying US-domiciled China ETFs may have to pay both Chinese and US taxes.

Investors should always ask whether the ETF they are buying is an Australian-domiciled ETF, with local portfolio management and custody. Or whether it is a feeder fund.

Some ETFs use swaps (are “synthetic”) to track their index

Some ETFs use swaps to track their indexes. Swaps are derivatives issued by investment banks (like Credit Suisse, Citi, UBS) that give certain investment exposures. The risk with swaps is that if the investment bank issuing them goes bust, then investors using swap-backed ETFs could be in trouble. In Australia, synthetic ETFs have declined in prevalence in recent years.

Closure risk: if funds fail to attract enough assets

When ETFs fail to generate enough investor interest, they are sometimes closed or have their strategies changed. This can be problematic for investors in the shuttered or changed ETF, who are forced to sell out. Large ETFs are safe from being shuttered or changed, as ETF providers are confident in investor demand. In general, a guideline is $40 million – ETFs with more than $40 million in assets under management have never been closed in Australia.

However, ETFs with less than $40 million can be safe too. If they are new, for instance, or ETF providers are committed to their futures, or the funds form part of their brand identity.