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Risks of investing in ETFs

ETFs can be high risk and complex and may not be suitable for retail investors, so you should make sure you understand all the risks involved before you invest. You should also be aware of investments called ETNs (Exchange Traded Notes) and ETCs (Exchange Traded Commodities) which are often marketed in the same category as ETFs. These carry similar, and sometimes higher, risks than ETFs.

Investment risk

The price of ETFs will fluctuate, reflecting changes in the value of underlying assets or derivatives, so the value of your investment may rise or fall.

Some ETFs rely on complex investment techniques, or hold riskier underlying assets, to achieve their objectives. These techniques may include the use of derivatives, such as contract for differences, instead of actual investment in the underlying securities. The use of derivatives may be extensive and may therefore significantly increase the risk profile of the ETF concerned. Please therefore always read the documentation provided to ensure you fully understand the risks you are taking on before you invest.

Counterparty risk

This is the major drawback of using derivatives or futures to replicate underlying assets or an index. If the other side of the derivative gets into trouble, this may affect the value of your investment. In 2008, a numbers of ETCs were suspended from trading because the counterparty was AIG. Since then, providers have taken measures such as using multiple counterparties or holding collateral, so if the counterparty collapses they can draw on this to pay returns to investors. Not all ETCs are collateralised and it is important to look at the structure of a particular ETC described in its prospectus. ETFs and ETCs are not covered directly under the Financial Services Compensation Scheme.

Tracking error

ETFs are likely to underperform the index or benchmark they are tracking over the longer term because of the impact of fees and other costs. Tracking error varies between different ETFs depending on the approach chosen to replicate the index. For example, the approach to replication may lead to some illiquid or small cap stocks being omitted, which in turn may lead to a difference in the performance compared to the benchmark the ETF is tracking. If dividends are not reinvested immediately, this might result in underperformance in a strongly rising market. There may be market conditions, such as during periods of market volatility, when the tracking error increases.

Currency

If an ETF’s underlying investments are in a currency different to the denominated currency of the ETF, there will be foreign exchange risk meaning that, for example, an index might rise but its currency might fall against sterling resulting in a smaller or even no gain to the ETF investor.

Volatility

All investments are likely to experience volatility but some ETFs and ETCs are likely to be generally higher risk investments given the nature of the underlying asset.

Tax

Tax is subject to change that could affect your investment in the future. In some cases, you may incur income tax on your proceeds when you sell rather than capital gains tax. You may wish to check with the provider whether a particular ETF has distributor or reporting status which would avoid this problem. If you want to hold a particular ETF or ETC in a SIPP or ISA, you may wish to check that you can do this. Not all are eligible for inclusion.

OUR AWARDS

Past performance is not a reliable indicator of future returns

The value of your investment can go down as well as up, and you can get back less than you originally invested.

The Bestinvest Online Investment Service, including any account analysis and investment reports provided by our guidance services, is an online execution-only dealing service for investors who want to make their own investment decisions. It does not provide advice on the suitability of products and investments; if you are unsure about the suitability of any investment you should seek professional advice. Clients of our Investment Advisory Service and Managed Portfolio Service can use the website to obtain current valuations of their investments but cannot trade on these accounts online and should call their adviser if they wish to discuss changes to their investments.

Past performance or any yields quoted should not be considered reliable indicators of future returns. Restricted advice can be provided as part of other services offered by Bestinvest, upon request and on a fee basis. Before investing in funds please check the specific risk factors on the key features document or refer to our risk warning notice as some funds can be high risk or complex; they may also have risks relating to the geographical area, industry sector and/or underlying assets in which they invest. Prevailing tax rates and relief are dependent on your individual circumstances and are subject to change.

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© Tilney Bestinvest Group Ltd 2016.

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