Making ETFs Safer

PadlockNikko Asset Management Asia Limited, the fund manager of the Nikko AM Singapore STI ETF (SGX: G3B), recently announced that the Exchange Traded Fund will undergo a change in its investment focus with effect from 29 April 2013.

Index trackers aim to match the performance of the index they are meant to mimic as closely as possible. For NAM SG STI ETF, it has previously sought to replicate the performance of the Straits Times Index (SGX: ^STI) by two methods. They are:

  1. Investing all or most of the ETF’s assets in the shares of the components of the STI in ‘substantially the same weightings as reflected in the Index’.
  2. Or crucially, through the use of financial derivatives or shares that are not components of the STI.

After the change in the investment focus of the ETF, it will stop using financial derivatives.

This is an important change for investors to consider. The use of financial derivatives has been described by Warren Buffett as ‘financial weapons of mass destruction’ partly because of their leveraged nature (as in options, warrants, and the like). The use of leverage can be dangerous for any investment strategy and should be used with care.

Derivatives might unwittingly expose investors to counter-party risks, which are often hidden during benign economic conditions. But they could come into play during crises.

A good example would be how major financial institutions in the western world were needlessly intertwined by derivatives, setting up a domino-effect of ‘one fallen bank after another’ during the 2007/2009 Global Financial Crisis.

The change in NAM SG STI ETF’s investment focus seems like a good step towards conservatism for its investors.

As an aside, the other major STI tracker ETF that’s available in the market comes from State Street Global Advisors through its SPDR Straits Times Index ETF (SGX: ES3). Currently, the SPDR STI ETF includes the use of financial derivatives as part of its allowable investment-universe in its quest to match the STI.

However, the SPDR STI ETF is operating under the guidelines of the CPF Investment Scheme, which states that ‘use of financial derivatives to replicate index performance (i.e. including but not limited to synthetic replication) is not allowed” and can only be used for ‘hedging and portfolio efficient portfolio management.  This creates a layer of conservative-protection for investors as ETFs can become dangerous if synthetic-replication of an index’s performance is used.

The Foolish Bottom Line

ETFs have been a great development for investors who are looking for easily accessible diversification without the need for large sums of money. But, it is important to know the financial condition and business prospects of companies when investing in individual shares. It is also important to know how an ETF is tracking its underlying investments. Consequently, it is important to read the fact sheet accompanying the ETF carefully.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Contributor Chong Ser Jing doesn’t own shares in any companies mentioned.