Notes on Investment Risks
An open-ended investment fund is a type of investment that – like other securities – involves risks. The general principle here is that the risks increase with the opportunities, which means the greater the chances of return for an investment fund, the higher the risks of suffering losses with the investment.
Special Risks of Exchange Traded Funds
Exchange Traded Funds (ETFs) are exchange-traded mutual funds that track the performance of an index, such as the DAX. They are also known as passive index funds. In contrast to active investment strategies, which want to achieve an over-return (outperformance) compared to a comparison index (benchmark) by selecting individual securities (stock picking) and determining favorable times for entry and exit (market timing), this is a passive investment strategy designed not to outperform a benchmark, but to replicate it at the lowest possible cost. The following specific risks exist with ETFs:
Since ETFs passively replicate an underlying index and are not actively managed, they generally bear the basic risks of the underlying indices. ETFs therefore fluctuate in direct proportion to their underlying. The risk-return profile of ETFs and their underlying indices are therefore very similar. If the DAX falls For example, by 10%, the price of an ETF that tracks the DAX will also fall by around 10%.
The investment risk increases with the increasing specialization of an ETF, for example in a certain region, industry or currency. However, this increased risk can also result in increased earnings opportunities.
ETFs are also subject to replication risk, which means that there may be differences between the value of the index and the ETF (tracking error). This tracking error can go beyond the difference in performance due to ETF fees. Such a deviation can for example, can be caused by cash balances, rebalancing, corporate actions, dividend payments or tax treatment of dividends.
There is also a counterparty risk for synthetic replicating ETFs. If a swap counterparty fails to meet its payment obligations, the investor may lose money.
Risk of transfer or termination of the fund:
Under certain conditions, both the transfer of the fund to another fund and the termination of management by the capital management company are possible. In the event of the transfer, continued administration can take place on poorer terms. In the event of termination, there is a risk of (future) lost profits.
If ETFs and their underlying components are traded on different exchanges with different trading hours, there is a risk that transactions in these ETFs will be carried out outside the trading hours of the respective components. This may lead to a difference in performance compared to the underlying index.
An investment fund can enter into securities lending transactions to optimize returns. If a borrower is unable to meet his return obligation and the security provided has lost value, the investment fund is at risk of losses.
General risks of Mutual Funds
Since the investment fund is invested in financial instruments, the value of your investment fund shares is significantly influenced by the economic trend and developments on the capital markets. Even a broad diversification of investment funds cannot prevent a disadvantageous market development from leading to a decline in value and thus to loss of assets.
Shares in open-ended investment funds can normally be redeemed every trading day at the applicable share value. The share value is subject to fluctuations. The magnitude and frequency of these fluctuations is called volatility and is calculated using various historical indicators. Especially in the case of a short-term investment horizon, there is an increased risk of loss in the event of high volatility, because losses in value can no longer be “sat out”. Mutual funds with a high equity component are generally more volatile than mutual funds with a high bond component.
The opportunities and, in mirror image, the risks of an investment fund increase with an increasing specialization in certain investment areas (e.g. regions, industries or currencies), because this reduces the diversification effect.
Mutual funds can invest in derivatives (e.g. options, financial futures contracts, swaps). The use of derivatives can involve risks that go beyond the risks of other financial instruments.
The contractual terms of the investment fund may stipulate that the fund company may, in certain exceptional situations, suspend the redemption of fund units up to a maximum of two and a half years. The fund units cannot therefore be redeemed during the suspension period. If sold on the stock exchange, if at all possible, significant discounts to the actual unit value must be taken into account. Furthermore, as a result of the suspension, there may even be a liquidation of the fund’s assets, which is usually associated with loss of assets for the investor.
Income from investment funds is subject to income tax for investors. Changes in the tax framework for investment income can lead to a change in the tax burden.
Real Estate as an asset class may comprise investments in residential, commercial as well as special purpose real estate. The investment may be made directly by acquiring real property or indirectly by investing in real estate funds, Real Estate Investment Trusts (REITs) or real estate companies.
Investments in real estate are, inter alia, subject to the following risks:
Return risk: The (direct) investment in real estate requires substantial financial resources. Amortisation takes place by renting out the real estate. This periodic return can easily be interrupted which may endanger the timely amortisation of the investment.
Valuation risk: The valuation of real estate is subject to various uncertainties. In addition, there are regionally segmented markets. Thus, there is substantial risk of paying too much for the purchase of a property or changing valuations due to a change in the environment.
Liquidity risk: Real estate is a relatively illiquid asset class. The sale process might take a considerable period of time.
Transaction costs: The process of valuation, sale / purchase and transfer causes relatively high costs compared to investments in securities.
Exchange rate risk: Indirect investments in real estate may be subject to the general exchange rate risks.
Investments denominated in a foreign currency are a way to diversify your portfolio. In addition, investments in all other asset classes might be associated with foreign currency risks.
Investments in foreign currency are, inter alia, subject to the following risks:
Exchange rate risk: Changes in the exchange rate of different currencies may have a substantial influence on the performance of an investment. Even in the event of the investment performing well, the value might deteriorate for individual investors due to unfavourable exchange rates.
Risk of changing interest rates: Changes in the rate of interest in the investor’s domestic market or foreign market may cause changes in the exchange rate due to considerable capital movements.
Regulatory risk: Regulatory authorities and/or central banks play a decisive role in the fixing or management of its country’s exchange rate. They might intervene for macroeconomic reasons. This poses additional risks, which are hard to foresee for the individual investor.