ETFs, CFDs and structured warrants on the market...

Clarification: A commenter has pointed out that I missed a link that countered the points raised on how ETFs are created. The problems with ETFs lies with new form of ETFs which are swap based i.e. derivatives based[Link]. Traditional ETFs hold real assets and have generally tracked the indexes/commodity/stocks backet closely. About half the ETFs on the SGX are swap based[Link]i.e synthetic. My experience monitoring a number of ETFs listed on the US markets, especially those that offer leverage i.e. double long, double short, triple long, triple short which are typically swap based is they become decorrelated over time with the sector or stock the are supposed to be linked to. These derivative based ETFs have come under the scrutiny of US regulators who have issued warnings on these products[Link].

In our quest to become a financial centre, the authorities have allowed various products/derivatives to be traded on the stock exchange. I'm not talking about structured products like the minibonds which are sold at the banks but various instruments traded on the stock exchange. There is this eagerness to just keep up with innovation elsewhere to encourage higher trading volume in our markets so that investment banks will set up shop here hire people, create and market various products. So far so good - jobs are created, products are created, banks make money ...everyone is happy...so you think. You rarely find articles in the Singapore papers or media critical of these products....nobody says these investment banks or brokerages are in some sense ripping you off. The problem is whatever these investment banks make, they make from you the investor....so the more they profits they make, the more you lose - this is not a win-win situation. I'll talk about 3 of these ETFs, structured warrants and CFD. Just remember if you can't figure out what they are, don't touch them.

ETFs (Exchange traded funds) have been marketed to Singapore investors as:

"Funds traded on SGX are known as Exchange Traded Funds, or ETFs. These funds generally aim to track indices like STI, MSCI India etc. This means that by investing in ETFs, you are effectively investing in the price movements of the component stocks in the underlying indices."[Link]

Investors are told in the marketing material that ETFs are superior to unit trusts because there no sales charge, and lower management fees than traditional funds. But how does it work? ...How do investment banks create an ETF on say on the STI, Gold, US financial sector, Hang Seng Index? You get an idea of how it is created in this article [What ETFs really are]. When you buy an ETF, you're sold a basket of derivatives, the fair value of which is known only to the managers of the ETF. Over time they can be decorrelated with the underlying basket of securities or index because the managers of these products can 'nickel and dime' you and your investment end up severely underperforming the index it is supposed to be linked to. Here is the video of a guy who tracked a number of ETFs on the US market and this is what he found: [Link].

Structured Warrants

"A structured warrant is a form of structured investment products issued by a third-party financial institution over a wide range of assets, including the shares of an un-related listed company, a basket of companies' shares or an index, and traded on SGX.

Structured warrants can be issued either as a call or put warrant. A call (put) warrant gives the holder a right, but not the obligation, to buy from (sell to) the issuer the underlying asset at a predetermined price, also known as the exercise price, on or before the expiry date, depending on the exercise style of the warrant.

In general, structured warrants enable investors to express their view of the performance of the underlying asset in a bullish or bearish market, at a significant degree of leverage over the life of the structured warrant. In addition, put warrants may be used by investors to hedge against the downside risk of one’s investment holdings." [Link]

The reason why you shouldn't buy these structured warrants in Singapore is they are frequently over-priced by the market maker who price in a huge premium which he can bring down over time. What this means is that these instruments have a higher than fair probability of depreciating over time to cause you losses and earn fat profits for the investment bank that operate as a market maker for the products. It will be interesting if MAS can make SGX release data on how much profits investment banks have made and how much investors have lost on these products. As for the use of these warrants for hedging ...forget it...the overpricing and expiry makes them useless for hedging.

CFDs

CFDs are offered to investors by several brokerages in Singapore. These products allow the investor to leverage up to 6-7 times their capital on a stock. The brokerage offering the product is the counterparty. So if you go and buy $20K worth of DBS CFD, the brokerage takes the opposite position. They make money via the buy-sell spread, brokerage fee and the loan the give you to leverage. What the try to do is balance their long and short exposure so they make risk free returns. They do this by limiting the amount of long or short trades for a given stock. Because of the leverage, buying CFDs is more like gambling than investing. While it is more transparent that the other 2 products, the odds are stacked in favor of the brokerage firm just like a casino ...the odds are against the investor.

Just like other bad financial products, the marketing material for these products tend to describe how useful and good they are. They do not explain how investment banks and brokerages make money off amatuer investors/traders from these products. My advice is to avoid them completely as the odds are heavily stacked against you....