ETFs and CFDs: Too scary, or right up your street?

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, easy and safe but are Exchange Traded Funds and Contracts for Difference scarier than you think?

 

 

Exchange traded funds (ETFs) are traded like shares on the Australian Stock Exchange (ASX), but instead of trading shares of ownership in a company, individuals trade units in managed funds. 

 

Conventional ETFs aim to achieve the same return as a certain benchmark or market index, by investing in the same securities as the benchmark (or a representative sample). On the other hand, synthetic ETFs try to mirror the return of a particular benchmark by holding derivative products with an investment bank normally acting as the counterparty.

 

Philip Gray from Morningstar says the ETF market in Australia is still in its infancy, worth about $3bn compared to $330bn traded in unlisted managed funds.

 

To recap, a managed fund invests in a range of assets such as Australian and international equities, fixed-income and property trusts. Hence, trading a single ETF already involves plenty of diversification.

 

The upside to trading ETFs is that you pay a lower management fee than you would otherwise pay if you directly purchased into a managed fund.

 

“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.

 

Trading ETFs is also a relatively tax-effective investment strategy since you can receive franking credits and you pay relatively small capital gains tax (CGT) because the portfolio turnover is relatively lower than under a managed fund.

 

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 suit almost any type of investor - it ultimately depends on what kind of exposure you want (such as Asian equities or gold) and finding a fund that invests in 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.

 

 

However, even if ETFs try to mirror a benchmark, it cannot be guaranteed that it will do so.

 

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 attract an especially high level of risk because they do not hold the physical, underlying securities and face the possibility of the counterparty defaulting and not meeting its obligations to the ETF.

 

Finally, the tax rules differ for synthetic and conventional ETFs and this might significantly alter your returns.

 

If you decide to trade ETFs, take these steps to protect yourself:

 

1. Understand what you’re buying. Make sure you understand how an ETF actually works. That goes double for complicated ETFs employing leverage and derivatives to punt on risky assets and foreign markets where there is less liquidity. So far, ETFs haven’t experienced a major market dislocation. No one knows how they will perform under stress. 

 

2. Beware conflicts of interest. Banks often fulfil the dual role of ETF provider and derivatives counterparty to earn more fees. You could do your dough if your ETF provider is unable to meet its obligations.

 

3. Check collateral. Make sure the collateral your counterparty is obligated to post against derivative positions is high quality. 

 

4. Beware of 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 is not hedged against currency fluctuations, then movements in the exchange rate could impact the value of the fund. In other words, you’ll have an exchange rate risk.

 

5. Understand ETF performance. How your ETF performs (particularly if it’s a synthetic ETF) may be very different from its underlying assets. For example, an ETF might only invest in the largest stocks of an index to reduce costs.

 

 

Contracts for difference (CFDs) are an agreement between two parties (buyer and seller) to exchange the difference in the price of a security, from the time the contract opens to the time it closes. 

 

If the value of the security rises, the seller pays the buyer the difference in value and vice versa.

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.

 

Most CFD enthusiasts tend to be very frequent traders rather than investors, where a position is held for only three or four days.

 

Some CFDs can be traded on the ASX, whilst others can be traded over the counter with a CFD provider. If you’re trading in the latter form, you need to read the provider’s terms and conditions. Some CFDs are expressed in foreign currency, exposing it to fluctuations in the exchange rate.

 

 

It’s important to understand CFDs are a leveraged product, which means your profits or losses can greatly exceed the amount you initially invest. 

 

Example: 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). Your CFD provider says you need to put down a 5% margin, so you put down $1,000 (0.05 x $20,000). 

 

If the share price rose by $2, you would make $8,000 (4,000 x $2). Nice, huh?

 

However, if the share price fell by $2, you would need to fess up $8,000. Clearly, CFDs come with an especially high level of risk attached.

 

Peter Mathers, Director of Trading Lounge, says CFDs are not suitable for mum and dad investors.

 

“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.

Counterparty risk

 

As with ETFs, an additional risk is that the CFD provider may not have enough funds to pay you if you win a large contract.

 

 

If you lose the contract, the CFD provider will demand that you maintain your trading account at a minimum balance, so they can continue to execute trades. This would be pretty hard from your end, if the market moves against you. 

 

 

Depending on which kind of CFD you’re trading, you will face the added risk of the underlying asset. 

For example, trading in share CFDs means your gains and losses will be influenced by the equities market; trading in currency CFDs will expose you to the volatility of the forex market. 

 

In other words, you need to understand the underlying market your CFD is concerned with.

 

-- By Stephanie Hanna