Friday, August 7, 2009

ETFs - The Hidden Danger

I have been an advocate for ETFs for a while, just as I was an advocate of the now infamous Mini Bonds.

People always have the opinion that in the stock world, an index is the only 'stock' that is almost 100% sure to go UP. That is absolutely true! An index will have no mercy on those lousy, money-losing stocks. If an index component stock does not perform, sorry, it will be kicked out of the index. A recent example is Yangzijiang being removed from the Straits Times Index (FTSTI).

An ETF is said to track the underlying stock index closely (usually with an error of less than 5%?). In the case, an ETF will always go UP in the long term.

Is this true? True to a certain extent. But then I just found out recently that both STI ETF and DBS STI ETF have clauses in their perspectus to allow 100% derivatives. What does it mean? This means the ETF can choose to hold derivatives of the index component stocks, instead of holding the REAL stocks.

What is the consequence? If one of the issuer/market maker of the derivatives goes burst, like Lehman Brothers, then the ETF may suffer significant loss.

So if you consider investing in an ETF, please do do your homework. A look into their latest financial report may be a worthwhile endeavour.

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