This article was first published by True Wealth publishing
Gain exposure to the stock index is one of the best ways for the average investor to access the stock market. It’s a simple, low cost and provides instant diversification. Plus study after study has shown that even the best of the unit trust funds and investment funds do not outperform consistently the corresponding indicator.
But you can’t buy an index directly. You need to use the investment product, such as ETF or index fund, a “special”. It is also possible to actively trade indices using derivatives (more on this later) or CFD (contracts for difference).
ETFs and index funds are good for investors who want to invest in the index over a long period of time – buy and hold investor. As previously mentioned, professional money managers’ returns over time can’t outgrow constantly, these other passive investments.
Trading CFDs on indices is investors that want a little more work and who understand how these specialized products. Actively trading index CFDs also requires more time, effort and analysis than just buying and holding the ETF. So this is not for everyone. (An example of how Indicators Trading using CFD’s work can be found here.)regardless of whether you want to buy and hold the ETF, or actively trading CFDs, you will be exposed to a variety of risks. Here are four of them.
# 1 counterparty risk
This applies to financial products such as swaps or derivatives used to provide an index. A common example is “synthetic” ETFs.
Here’s how a synthetic ETF works: instead of holding the underlying index Securities ETF investors have a “swap” and other safeguards that used to be the holding company.
Swap another contract with a financial firm or “counterparty” that promises to pay the index return to the fund. Using derivatives rather than buying the underlying assets – reduces fund costs of those savings are passed on to investors.
While there are regulations that may limit the ETF you know any one contractor, the fact remains that if the counterparty should become unable to pay investors in the synthetic ETF can lose money. If that institution goes bankrupt, the ETF loses money and this will be passed on to investors.
# 2 foreign exchange risk
If you have exposure in the index in a currency different from what is in your account, such as the US dollar, the change in exchange rates will affect your performance.
For example, let’s say you use Singapore dollars to buy dollar investment that tracks the US S&P 500 index. If the ETF rises 15 percent in value (net of transaction costs), but the Singapore dollar gains 2 percent in value terms compared with the US dollar, you make only 13 percent (if you sell the ETF at that time).
But if the Singapore dollar lost 2 percent compared with the U.S. Dollar, your return will be 17 percent. So foreign exchange risk can work in your favor.
To avoid foreign exchange risk, look for index products that are verified to work. This means that there is little risk from changes in foreign currency exchange rates.
# 3 liquidity
This is especially true for ETFs. Most people buy and sell most of the liquid is the most traded – ETFs. But there are a lot of boxes that have the liquidity to very low – that is, there are many willing buyers or sellers in exchange-traded funds.
This can be a problem if you need to buy or sell this ETF in a hurry, or if you have a large number of stocks in ETF liquidity.
When trading volume is low, it may take some time to get filled and you may not get the best price. So look for those with the highest trading volumes daily.
# 4 leveraged and inverse index products
If you use any investment product that uses leverage or derivatives, for example, “inverse” ETFs you have to be careful of the leverage effect on the price of the ETF. Since Singapore’s approval of the rules of leveraged and inverse exchange-traded funds earlier this year, expect to hear more about in the coming months.
Here’s why these financial instruments should be used only by experienced investors who can withstand plenty of risk. We’ll use leveraged and inverse ETFs as an example:
Leveraged ETFs seek to engineer offices are 2 or 3 times the underlying index. An example of this is the UltraPro short S&P 500 ETF (New York Stock Exchange; ticker: SPXU). The goal is to earn 3 times the opposite of what the S&P 500 index return on a particular day. So, if the S&P 500 losing 1 percent in a single day, SPXU will earn 3 percent on that day.
The inverse ETFs do the opposite of what index it’s tied to. For example, ProShares Short S&P 500 ETF (New York Stock Exchange; ticker: SH) aims to go even if the S&P 500 index falling and get off at the S&P 500 index rising. So, if the S&P 500 falls 1 percent, the SH rises 1%. And if the S&P 500 rising 1 percent, the SH falls 1 percent.
Leveraged and inverse ETFs use derivatives. These are tools that are “worth” their value from underlying assets – such as gold, share price or stock index. Derivatives allow ETF managers to send the top or the bottom of the returns of the target index.
Unless you’re a day or short term trader, leveraged index products may not be worth the added risk and volatility.
You should still Index though
But don’t let these risks prevent you from investing in a stock index using index CFD. If you understand what you are buying and are aware of the risks involved, the index of investment or trading, can be a very profitable strategy.