How safe is an ETF?

[SL100]

Hi,

Following advice on this board I am interested in investing in index tracking ETFs but am confused at the risks and in particular whether an index tracking ETF actually owns shares in all the companies in the index it is tracking.

In other words am I buying shares in something which is effectively a collection of shares in the index and if it fails or some reason will I at least own my 'share' of its shares?

From a Wikipedia definition (not wanting to start a tangent debate on the quality of info on Wikipedia...):

"Some index ETFs invest 100% of their assets proportionately in the securities underlying an index, a manner of investing called "replication." Other index ETFs use "representative sampling," investing 80% to 95% of their assets in the securities of an underlying index and investing the remaining 5% to 20% of their assets in other holdings, such as futures, option and swap contracts, and securities not in the underlying index, that the fund's adviser believes will help the ETF to achieve its investment objective. For index ETFs that invest in indexes with thousands of underlying securities, some index ETFs employ "aggressive sampling" and invest in only a tiny percentage of the underlying securities."

What I think I would like is a 'replication' index tracking ETF fund.

Does anyone know how to identify which index ETFs (that can be invested in from Ireland) are of this type?

Thanks in advance for any help!!

 

[PMU]

In other words am I buying shares in something which is effectively a collection of shares in the index and if it fails or some reason will I at least own my 'share' of its shares?

I think I covered this in this post: http://www.askaboutmoney.com/showthread.php?t=118909

What I think I would like is a 'replication' index tracking ETF fund. Does anyone know how to identify which index ETFs (that can be invested in from Ireland) are of this type?

If you go to the web sites of the providers of the ETFs you can buy on the London and Dublin stock exchanges (e.g. iShares, Lyxor, db-trackers, ETF Securities, etc.) a quick look at the full prospectus of the ETF will tell you.

The db-trackers web site is probably the best in describing how synthetic replication works.

 

[Rory Gillen]

In response to the initial query 'How safe is an ETF' you might find these additional comments useful, although technical.

In terms of how safe ETFs are, I am assuming you are referring to risks other than price risk. In that case, the main issue to be concerned with is counter-party risk i.e. the risks that the fund is exposed to outside your control.

To understand this issue, it is first important to outline that ETFs obtain their exposure to the relevant underlying index in one of two ways. The first is by buying the actual stocks in the relevant index. The second is by buying a derivative contract that in effect allows the fund to replicate the performance of the index.

For a fund that buys its own stocks there is no counterparty risk. It owns its own assets and that is that. For a fund that buys derivative contracts, it is then dependent on a third party to deliver on that contract. Post the Lehamns Bros debacle, everyone became extremely nervous about counterparty risk.

It is important to point out, however, that all EU listed ETFs (as opposed to US listed ETFs for example) are required to keep counterparty risk to 10% or less of their assets. iShares ETFs have an internal rule that limits counterparty risk to 5% and Deutsche Bank is eliminating counterparty risk altogether (I believe) from its ETFs. I am not sure to the same extent about the specific rules governing US-listed ETFs on the counterparty risk issue but I'd be amazed if they were not similar.

It's worth remembering that counterparty risk is much higher with Irish unit-linked funds. If you buy into such a fund, then the assets of such a fund are not separate to the insurance company assets. The significance of this point is that if the insurance company failed (went bust) then the fund's assets would not be treated separately to the insurance company and could be lost. To that extent, there is less risk in even the derivative-based ETFs.

Rory