Exchange Traded Funds (ETFs) / Index Funds (IFs)

Depending on how you see them, ETFs could be a subset of IFs. John Bogle of Vanguard Group fame (see earlier post on Index Investing), was initially against ETFs for fear that it encouraged trading and consequently increased costs.

Yet ETFs has other risks. Of these, let me bring up Liquidity Risk. The ETF units are bought and sold, just like those in the market. At times, even when you truly want to sell them, there may be no takers (no demand). Or you may need to sell at a price lower than what you bought them for. There is no maximum limit to your losses.

Also, cash-based ETFs may be involved in stock lending. This means after buying the stocks and/ or bonds, they loan out the ownership certificates to hedge funds or bank traders who bet on the stock/bond values. In return, the ETF manager/custodian earns fees; and to achieve safety takes a collateral. The manager may further invest the collateral in money market securities. Problems (potential losses) arise when (a) the hedge funds/bank trades bets go wrong and the collateral is insufficient to repay the ETF manager; or (b) those money market securities themselves go south.

All these lending and investing lead to more costs while the returns are not guaranteed.

Thus should you wish to invest, please consider the cost. I knew someone who lost $20 000 or so at one go. (This was probably in stock/equities.) I am not sure if I would have survived such a loss; that person definitely did.

Do refer to the below for your own independent analysis:

1. (Run by the Monetary Authority of Singapore) http://www.moneysense.gov.sg/Understanding-Financial-Products/Investments/Types-of-Investments/Exchange-Traded-Funds.aspx

2. http://www.etf.com/etf-education-center/21031-understanding-securities-lending.html

3. (March 2014 – HSBC ends stock lending) http://www.ft.com/intl/cms/s/0/831726de-af5d-11e3-bea5-00144feab7de.html#axzz36ekCuXpF

4. (Feb 2013 – Lawsuit against securities lending) http://finance.yahoo.com/news/lawsuit-raises-awareness-over-etf-210254085.html

5. (Actual instances of stock/securities lending) http://www.ft.com/intl/cms/s/0/740b1e6a-ce08-11e3-9dfd-00144feabdc0.html#axzz36ekCuXpF”>

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