The Beginner’s Guide to Understanding ETFs
by: Tam Ging Wien
author of REITs to Riches: Everything You Need to Know About Investing Profitably in REITs. The book is available at all Kinokuniya bookstores in Singapore and as a downloadable PDF ebook.
The article first appeared on ProButterfly.com on 06-Nov-2017.
ETFs are excellent vehicles for investors who want to spend little time monitoring their investments, yet want investment returns aligned with the markets. ETF investing in the long term will outpace inflation and fixed deposits; compounding wealth over the long term.
Introduction to ETFs
Exchange traded funds (ETFs) are investment funds which are listed and traded on a stock exchange. When you buy into an ETF, your contribution is pooled together with other investors and invested according to the ETF’s investment objective. They are similar to unit trusts which is an investment vehicle most people are familiar with. ETFs however differ from unit trusts in that they are traded over an exchange and therefore can be bought and sold quickly throughout the day while the market is open.
ETFs as its name suggest is fund that holds underlying assets such as stocks, commodities, bonds or a combination of their respective derivatives. The ownership of these underlying assets are sub-divided into shares that are held by the shareholders which therefore indirectly own the underlying assets.
Unlike unit trust which are bought-in or redeemed at the net asset value (NAV) per share. Shares of an ETFs instead and bought and sold based on market prices which are influenced by demand and supply. Therefore if there is a temporary surge in demand, the ETF could trade above its NAV and vice-versa. Due to the fact that most ETFs track an established and publicly known index, the ETF within a short term should revert back to near its NAV.
Purpose of ETFs
ETFs were introduced as a response to research that appear to show that many professionally managed active funds do not generate market index beating returns in the long term.
Therefore, instead of actively trying to manage and outperform the markets, why not just track the market indexes instead? As a result many ETFs are designed to track and replicate the performance of a particular underlying index or assess class. ETFs tracking a particular index would therefore in theory reflect the same percentage gain or loss of the index.
Take for example the FTSE Singapore Straits Times Index (STI) which is made up of the 30 the largest companies by market capitalisation listed on the SGX. The weights of each of the component stocks are based on the market capitalisation of the individual component stocks. Therefore ETFs tracking the STI would buy all the 30 underlying STI shares in the same proportion as the weights in the STI. If these weights are changed or component stocks altered, the ETF will adjust their holdings in the component stocks automatically. Currently there are 2 ETFs that track the STI:
- SPDR Straits Times Index ETF (SGX:ES3)
- Nikko AM Singapore STI ETF (SGX:G3B)
However before venturing into ETFs, it would be prudent to first understand the benefits and pitfalls of investing in ETFs.
Benefits of ETF Investing
Transparency in the context of financial investment refers to how much access an investor has to the information on the underlying assets and decisions on its buying and selling. If these information are make known to the public, it is said to be transparent.
The more transparent an investment is, the better and faster a decision can be made on the investment action. As many ETFs track established indexes, investors have full information of the weights and prices of each underlying asset, real time NAV estimates and real time trading prices throughout the trading day. Changes to components in the index would also be publicly announced which draws attention to changes in the ETFs underlying assets.
Simple and Flexible
When investors buy-in or redeem from a unit trust, they are really entering or exiting at the end of the trading day. This is because unit trust and other funds trade based on the net asset value (NAV) per share of the fund. At the end of the day after the markets are closed, the unit trust will tabulate and calculated its NAV for the day. Then and trade actions which enter or exit the unit trust will be based on this end of day NAV. Therefore an investor cannot trade a unit trust in and out on the same day.
ETFs on the other hand are publicly traded based through brokers on their share price on a willing buyer willing seller basis which does not require the NAV to be determined. ETFs receive high visibility on a stock exchange, therefore they are very liquid as investors can easily buy in or sell out of an ETF without having to incur penalties or charges.
For traders, multiple trade actions can also be taken such as buying on margin and selling short which allows ETFs to be used for hedging. ETFs also allow traders to place their orders using their broker’s flexible ordering system with features such as stop orders and limit orders, which allow investors to specify the price points at which they are willing to enter and exit. All these are not possible with conventional unit trust.
However, due to ETFs requiring investors to purchase through a broker, each transaction will incur a brokerage cost. Therefore if an investor is planning a dollar-cost-averaging investment strategy, ETFs would be rather unsuitable due to the high brokerage cost of each single transaction. Therefore unit trust would be better suited for investors who prefer the dollar-cost-averaging strategy.
As majority of ETFs track an established index, they do not need to be actively managed as the components of an index do not change frequently. Therefore, ETFs are insulated from frequent transaction cost which are predominant in other more actively managed fund which need to buy and sell assets to accommodate shareholders purchases and redemptions.
For the same reason above, unit trust and other actively managed funds require higher overheads to operate due to the need to hire more professional managers and execution teams. These managers need time and effort and draw upon research in order to make decisions on the fund’s portfolio. These funds therefore need to charge management fees in order to account for these cost which could be between 1% to 3% per year.
Due to their listing and trading on a stock exchange, ETFs have a higher visibility compared to unit trust funds. As a result, ETFs would require lower marketing, distribution and accounting expenses. Sales commissions to agents are also minimised.
As a result of these various factors, ETFs are able to reduce their management fees significantly. For ETFs, these fees are termed as “Expense Ratios” which can be as low as between 0.1% to 0.9%.
The SPDR STI and Nikko AM STI ETF have an expense ratio of 0.3% and 0.245% respectively. Simple switching from a unit trust to a ETF with the exact same asset holding portfolio could easily increase your annual year by 1% or more.
ETFs are indeed low expense funds!
Achieve Passive Long Term Compounding
As mentioned before, ETFs were introduced as a response to research that appear to show that many professionally managed active funds do not generate market index beating returns in the long term.
If many of these professional fund managers were not able to able to beat the markets, then likewise many retail investors with little investment knowledge are better off investing in an ETF instead of risking their hard earned money gambling in stocks which they have little understanding.
ETFs can also be used as an investment vehicle for junior investors who want to begin their investment journey but have not mustered the full confidence to pick specific stocks yet. This allows them to invest passively while still building up their knowledge, skills and experience. ETFs help provide them with foundational experience and built their investment confidence from a young age. Young readers or readers with younger children will smaller capital should be encouraged to begin their stock investment journey with ETFs.
ETFs are also great investment vehicles for investors who simply cannot afford the time to research, study and follow the counters they like. Busy executives, business people or even home makers who have their hands full taking care of the household could use ETFs as their passive investment strategies.
Market exposure and diversification
An index ETF inherently provides diversification across an entire index. ETFs offer exposure to a diverse variety of markets, including country-specific indices, industry sector-specific indices, bond indices, and commodities. An investor could easily with a small amount of capital achieve broad diversification across a wide variety of stocks just by investing in an ETF. An investor who wants exposure to a specific sector but don’t know enough to pick specific stocks could use an ETF to gain the exposure.
Take for instance an investor thinks that the market is at a high now and want to rotate their portfolio into gold and bonds to preserve their capital, they could sell out of their equities and purchase a gold and bond ETF. In Singapore, investors could use the SPDR Gold Shares ETF (SGX:O87) that tracks the direct performance of gold prices by buying into actual gold. For bonds, investors could use the ABF Singapore Bond Index Fund ETF (SGX:A35) with provides exposure to triple-A bonds backed by the Singapore government.
In another example, an investor who wants exposure to India could invest in the iShares MSCI India Index ETF (SGX:I98). Another investor who thinks that Hong Kong might be a better bet could invest in the Lyxor ETF Hong Kong (SGX:A9B).
Diversification is important in investing so that unexpected black swan events occurring in one particular stock have a minimal impact on the overall investor’s portfolio. The large pool off underlying assets would also be affected in varying degrees, some positively and some negatively. With broad based diversifications, ETFs are less volatile helps with investor’s emotional stability reducing the possibility of psychological panic selling.
On the flip side, diversification will not optimise an investor’s returns. There will be losers in a bull market and winners in a bear market. Due to the diversification effect of ETFs, winners in the portfolio are also diluted.
Pitfalls to Avoid When Investing in ETFs
As mentioned earlier, ETFs are exchange listed funds that holds underlying assets such as stocks, commodities, bonds or a combination of their respective derivatives.
When the ETF chooses to use only derivatives to mimic the index, these are known as “synthetic ETFs”. This is because they do not actually own the underlying asset, instead they take a position in the asset’s derivative contracts such as “swaps”, “options” or other forms of collateral to replicate owning the asset. These contracts require a counter-party to honour the promises. Investors are therefore relying on the creditworthiness of the counter-party to deliver the performance of the index to the fund. In the event that the counter party defaults on its promises, the contracts owned by the ETF become worthless and the ETF investor could lose their investments.
Some ETFs issuers choose to use “synthetic ETFs” as they are cheaper relative to the actual asset thereby reducing the cost to the ETF. These cost savings are passed back to the investors.
Specifically in Singapore, SGX has required the counter names for all synthetic ETFs listed in Singapore to be marked with the symbol “X” for the ease of identification.
Examples of ETFs in Singapore with potential counter-party risk are the “db x-trackers” ETF series which have Deutsche Bank AG as the market maker.
If a fund buys into the exact proportions of the index that it is tracking, it should in theory be able to perfectly mimic the index performance without errors.
However, due to multiple real world factors, the NAV of an ETF could deviate from the index. These deviations are known as tracking errors which could arise from one or more of the following factors:
- Reaction Time to Index Component Changes – When an index component changes, the ETFs would require time to dispose of some assets and acquire others. Due to the large holdings, an ETF would take time to complete these acquisitions and disposals in order to replicate the new components and proportions. This reaction time will result in tracking errors of the ETF during the transition period.
- Transaction Cost – ETFs incur transaction cost when buying or selling the underlying assets. These cost will reduce the performance compared to the index.
- Cash Holdings – ETFs will require to hold some cash for operational reasons. This cash holdings in the ETF would not optimise its NAV tracking against the index resulting in tracking errors.
- Exchange Rate Hedges – Some ETFs operate by holding assets in overseas markets and have hedges in place to protect against sudden adverse exchange rate movements. These hedges incur cost and reducing the ETF’s performance.
- Representative Sampling – Some ETFs in order to maintain a lower cost of operations and holdings chose to take up only major components of the index ignoring the smaller components. This is known a representative sampling as opposed to the full replication. Representative sampling will no doubt introduce tracking errors as the smaller components are not considered in the underlying portfolio.
- Bid-Ask Spreads of Underlying Assets – Tracking errors could arise due too significant bid-ask spreads of the underlying asset which the ETF needs to acquire to dispose in order to replicate an index. If these underlying assets are illiquid, the bid-ask spread will be wide resulting in larger cost to the ETF to acquire of dispose of its assets.
The estimated tracking errors of ETFs are usually listed in the ETF factsheet. For example, the SPDR STI ETF factsheet list the rolling 1-year tracking error as 0.0872%. This means that if the STI gains 10%, the investor buying into the SPDR STI ETF may see a gain of 9.9128%. This is considered a very low tracking error. ETFs that utilise derivatives extensively especially those that track commodity prices tend to have much higher tracking errors.
Exchange Rate Risk
Exchange rate risk is present in cross border ETFs where the ETF is listed and denominated in one currency but has a large and significant pool of its underlying assets reside or are traded in a different country or currency.
Exchange rates could move favourably or against an investor without any movements in the value of the underlying assets. Investors investing in ETFs which have cross boarder underlying assets should consider the currency exchange rate changes before investing.
ETFs just like any stocks are exposed to liquidity risk as the buying and selling depends on market demand and supply. Unlike a unit trust where the buy-ins and redemptions are completed by the fund manager. Therefore short term trading of ETFs could lead to variations between the share price and NAV per share of the ETF.
For ETFs which are heavily traded, the liquidity is said to be high and the bid-ask spread for the share price is narrow. However for thinly traded ETFs, liquidity could be a risk due to wider bid-ask spreads. As a result, investors may take longer to acquire or dispose the illiquid ETF shares. Likewise, the wider bid-ask spread may result in the investor not getting the optimal entry or exit price. For investors, it would be best to stick to ETFs which are frequently traded.
Underlying assets held by an ETF may also be illiquid and should an ETF sponsor fail to perform its obligations to provide a continuous quote in the ETF, the ETF shareholders may be left with a pool of assets which are difficult to dispose which exposes them to a potential erosion of value.
An ETF Investor’s Checklist
After shortlisting potential ETFs to invest in, an investor should make a detailed evaluation on the quality of the potential investment.
A checklist is beneficial to an investor as it helps minimize critical errors and structures our evaluation process thoroughly.
The checklist below is specifically prepared to assess risk related to investing in ETFs.
I hope you have enjoyed this educational piece.