Passive Management Risk
Traditional methods of investment management for an actively managed fund typically involve deliberate changes to a portfolio of securities based on judgement of economic, financial and market conditions, as well as factors specific to individual issuers. In contrast, the Underlying Funds are passive investments, meaning that the Underlying Fund Manager does not make active investment decisions in relation to the Index Issuers it invests in. The prospectus of each Underlying Fund states that the Underlying Fund Manager aims to buy and sell Index Securities in order to track the relevant Underlying Index, rather than making judgments about Index Issuers or wider market conditions. If an Index Issuer (or Index Issuers generally) were to perform poorly, the Underlying Fund Manager would not take any action, unless and until action would be required to
33 ensure that the Underlying Fund continues to track the relevant Underlying Index..
Tracking Risk
For a variety of reasons the Underlying Fund Manager may not always track the Underlying Indices exactly. As a result of this, the Index Securities held by an Underlying Fund may, over time, not exactly match the investment performance of the Underlying Index that the Underlying Fund tracks. The Manager may not be aware that a tracking error has occurred.
Where the Underlying Fund uses index replication to track an Underlying Index (described on page 20 and used by all Underlying Funds other than the Vanguard Emerging Markets Stock Index Fund ETF Shares and the Vanguard Total World Stock Index Fund ETF Shares), there is a risk that the Underlying Fund Manager will not able to exactly match changes to the Underlying Indices by buying and selling Index Securities, because the prices it pays and receives for Index Securities may not exactly match the prices used to adjust an Underlying Index. For example, there may be limited liquidity in relation to securities the Underlying Fund Manager is attempting to buy that pushes up the purchase price of those securities after an adjustment to the relevant Underlying Index, but before the Underlying Fund Manager can buy.
Where the Underlying Fund uses index sampling to track an Underlying Index (described on page 20 and used by the Vanguard Emerging Markets Stock Index Fund ETF Shares and the Vanguard Total World Stock Index Fund ETF Shares), there is a risk that the Index Securities selected by the Underlying Fund Manager (using its computer programs) will not provide the same investment performance as the Underlying Index.
There is also a risk that tracking errors arise due to human or systems errors, as index tracking is a complex exercise.
Some tracking errors mean that the value of an Underlying Fund's Index Securities increases in relation to the value of the relevant Underlying Index. However, some tracking errors mean the value of an Underlying Fund's Index Securities reduces in relation to the value of the Underlying Index. When this is the case, the Return generated by the Underlying Fund may be less than the Return on the relevant Underlying Index. Distributions Risk
The level of distributions that the Smartshares Funds receive from the Underlying Funds is dependent on the level of distributions paid by Index Issuers on the Index Securities (because distributions paid by Index Issuers to each Underlying Fund are passed on to holders of the relevant Underlying Shares (including the relevant Smartshares Fund) less certain fees and costs). The Manager has no influence over the dividend policies of Index Issuers or the Underlying Funds or over anything else that may affect the level of distributions paid by them. Accordingly, there is no guarantee of any particular level of distributions. Regulatory and Tax Risk
The Underlying Funds may be adversely affected by future changes in applicable laws, including tax laws, or by decisions taken by regulatory agencies enforcing those laws, which may affect the value of Underlying Shares or distributions made to holders of Underlying Shares (including the relevant Smartshares Fund). Halt, Suspension or Delisting Risk
The Underlying Shares are listed for trading on NYSE Arca (an exchange). Trading in the Underlying Shares may be halted or suspended or the Underlying Shares may be delisted which may mean the Manager is unable to trade Underlying Shares either temporarily or permanently.
The Underlying Funds also face the following risks in connection with investment in Index Securities:
Index Issuer Risk
Index Issuer risk occurs where the individual assets of an Underlying Fund fluctuate in value due to circumstances specifically applicable to a particular Index Issuer. This risk is mitigated to an extent because the Underlying Funds invest in a number of Index Issuers across a number of industries (and in some cases countries and regions) at approximately their relevant index weight. Therefore, the fluctuation in value of a single Index Issuer has a diluted effect on overall performance.
34 Country / Regional Risk
This is the risk that world events, such as political upheaval, financial troubles or natural disasters, will adversely affect the value of securities issued by companies in certain countries or regions. Most of the Underlying Funds have heavy exposure to certain countries or regions and will face a higher degree of country risk than that of a more geographically diversified international fund.
Currency Risk
The Underlying Funds pay distributions in US Dollars and the Underlying Shares are denominated in US Dollars. However, several of the Underlying Funds invest in entities domiciled outside of the US. These funds may be exposed to a currency risk based on the exchange rate between the currency the Returns are received in and the US dollar.
Market Risk
The Underlying Funds invest in broadly based portfolios of securities and there is a risk that the general level of the securities’ prices may decline, thereby adversely affecting the value of such investment. Securities are susceptible to general sharemarket fluctuations and to volatile increases and decreases in price as market confidence in and perceptions of their issuers change. These investor perceptions are unpredictable and may be based on various factors including expectations regarding government, economic, monetary and fiscal policies, inflation and interest rates, economic expansion or contraction, and global or regional political, economic, banking or financial market crises.
The value of securities can also be affected by their liquidity. For smaller stocks, where there can often be limited liquidity, a change in their indices weightings could have an effect on the level of demand in the market place. This in turn may impact the price an Underlying Fund has to trade at to track the relevant Underlying Index and the fluctuation in the price of the security may ultimately affect the Return received by the relevant Smartshares Fund.
Sector Risk
Other than the Vanguard Total World Stock Index Fund ETF Shares, each of the Underlying Funds invests in a particular market sector (either a subset of the United States stock market or a particular international region). That sector may be more volatile and less liquid than the market as a whole. Emerging Markets Risk
The Vanguard Emerging Markets Stock Index Fund ETF Shares and the Vanguard Total World Stock Index Fund ETF Shares are susceptible to emerging markets risk. This means that there is the chance that the value of the securities of companies located in emerging markets will be substantially more volatile, and substantially less liquid, than the securities of companies located in more developed markets because, among other factors, emerging markets can have greater custodial and operational risks, less developed legal, regulatory and accounting systems and greater political, social and economic instability than developed markets.