Exchange Traded Funds



What is an Exchange Traded Fund?

Exchange traded funds (ETFs) are open-ended investment funds listed and traded on a stock exchange. Your money is pooled with money from other investors and invested according to the ETF’s stated investment objective.

An ETF typically aims to produce a return that tracks or replicates a specific index such as a stock or commodity index. Such index tracking ETFs are passively managed by ETF managers and do not try to outperform the underlying index. Hence, index tracking ETFs have fees and charges that are usually lower than those of actively managed investment funds.

ETFs may have complex structures. They may be structured as cash-based ETFs or as synthetic ETFs, which involve the use of derivatives.

Some investment products have been categorised as Specified Investment Products (SIPs). Do check with your financial institution whether the product you are considering is an SIP. For information on the requirements in place when transacting SIPs, please refer to the consumer guide.

What is an index?

A stock market index is a representative sample of the stock market and is expressed as a single value to measure the relative value of the stock market.

What is the return?

You invest in an ETF by buying units in the ETF. There is capital gain when the price of the units rises above the price paid for them. Some ETFs also pay dividends.

Why do people invest in ETFs?

There are many ETFs to choose from. If you buy an ETF which tracks a share index, you gain exposure to the performance of the index. For example, investing in an ETF that tracks the Straits Times Index (STI) provides investors with exposure to the Singapore market.

You can gain this exposure without having to spend more money buying the component stocks of the index. In addition, fees and charges for ETFs tend to be lower than for actively managed investment funds as ETFs have lower management fees. There is also usually no sales charge, although any transactions in ETFs on the SGX would still be subject to brokerage commissions or transfer taxes associated with the trading and settlement through the SGX.

As ETFs are traded on a stock exchange, you can buy and sell units of ETFs throughout the trading day.

Are ETFs suitable for everyone?

Investing in ETFs may not be for everyone. They may not be suitable for you if you:

  • Want potentially higher returns BUT are not prepared for variable returns which include the risk of losing all or a substantial part of your original investment amount;
  • Do not understand how returns are determined or if you are unclear about the factors and scenarios that can affect returns;
  • Do not understand the risks associated with the ETF. Investors should be aware of the risks associated with the use of derivatives by ETFs, including the risk that the provider or counterparty of the derivative defaults.
  • Are not prepared to leave your money invested for long periods of time. A longer time horizon is generally preferred to ride out short term price fluctuations. But depending on the investor’s investment objective, some ETFs may be suitable for short term trading.
  • Are not familiar with the ETF manager and the ETF’s track record.

What is the maximum amount you can lose?

ETFs are not principal-guaranteed. You may lose all or a substantial amount of the money you invested in certain situations. The risks of investing in ETFs are described in the prospectus and product highlights sheet.

What to watch out for – what can cause me to lose money?

Some of the risks associated with investing in ETFs whether cash or synthetic include:

Risk What it means 
Market risk You are exposed to market risk or the volatility of the specific benchmark tracked. For example, the price performance of an ETF tracking the STI will be directly affected by the price fluctuations of the component stocks of the STI.
Tracking error Changes in an ETF’s net asset value (NAV) may not exactly correspond to price changes of the index. In cash-based ETFs, the manager may not be able to buy or sell the component stocks in their exact proportion, or adjust its underlying component stocks to keep up with market or weighting changes. Execution costs, investment constraints, or timing differences may also add to tracking error.
Foreign exchange risk

You are exposed to foreign exchange risk when you buy an ETF whose currency is different from your own.

Some ETFs may trade in a currency that is different from that of the underlying assets.

Liquidity risk Designated market makers provide liquidity in ETFs by providing continuous bid-ask prices throughout the trading day. But if the market maker fails to perform its duty due to insolvency, or extreme market conditions, liquidity of the ETF units in the secondary market may disappear, making it difficult for investors to sell their ETF units.
ETF’s traded price not reflective of NAV per unit An ETF’s traded price may not reflect NAV as the traded price is subject to market demand and supply conditions.
NAV is the net asset value of the fund, calculated at the end of each day while the indicative NAV is calculated periodically through the trading day. The indicative NAV will rise or fall correspondingly when the index value, which is based on the value of the index components, rises or falls.
Assets used in cash-based structures may be used for securities lending purposes. Investors are exposed to the risk that the borrower of the securities defaults and does not return the securities.

What types of ETFs are available?

ETFs typically aim to produce returns that track or replicate the performance an index. Here are some examples of types of ETFs available on the Singapore Exchange (SGX):

Equities/stocks These aim to track the performance of a stock index, such as the Straits Times Index (STI). If the stock index increases in value by 2%, the ETF's value should also increase by approximately 2%, less any fees.
Bonds ETFs can also track a specific bond index. Bond ETFs provide investors with exposure to bond indices.
Commodities Commodity ETFs track the movement of commodity indices. These ETFs may provide investors of the ETFs exposure to commodity indices.
Inverse (or ‘short’) ETFs track the inverse performance of indices. The short index moves inversely to its corresponding long index on a daily basis. If the long index drops by 2% in a day, the short index should increase by 2%. The inverse ETF tracking the short index should also increase by approximately 2% for the day, less any fees.

Investors should note that the inverse index is designed to track the inverse position of the long index on a daily basis and may not be suitable for long-term investment. If you invest in an ETF tracking an inverse index for more than a day, the returns you get may be completely uncorrelated to the inverse performance of the relevant long index.

How are ETFs structured and what do they invest in?

There are different ways to structure an ETF even if its investment objective is to track the same underlying index.

Cash-based ETF

Cash-based ETFs are ETFs that invest directly into the assets that make up the index. They may:

  • Invest in all of the index’s component stocks, bonds or assets.
  • Invest in a representative selection of the index’s component stocks, bonds or assets.

Synthetic ETF

Synthetic ETFs are ETFs that use derivative products such as swaps or access products (for example, participatory notes) to produce returns which track the relevant indices. The use of derivatives means:

  • More parties are involved, e.g. the swap counterparty or the access product issuer.
  • You are exposed to the risk that the swap counterparty or access product issuer defaults on its payment obligations under the swap or access product. Such a party may default if it becomes bankrupt or insolvent.
  • The amount of loss an investor suffers will depend on the ETF’s exposure to the counterparty or issuer.
    Synthetic ETFs that are swap-based may use either the unfunded or funded structure.

Swap-based (unfunded structure)

In an unfunded structure, the ETF buys and holds a basket of securities. The basket of securities may be completely unrelated to the index the ETF is tracking. The ETF then enters into a swap agreement with another entity known as the swap counterparty.

  • The ETF will pay out the return it earns from the basket of securities to the swap counterparty.
  • In exchange, the swap counterparty pays the index’s return to the ETF.

The ETF holds and retains control of the basket of securities even if the counterparty defaults. In addition, the ETF’s exposure to its swap counterparty is usually limited to 10% of the ETF’s net asset value. This means the ETF could lose up to 10% of its net asset value due to unpaid obligations from the swap counterparty. Additional losses may still be possible, for example, if the basket of securities is liquidated under adverse market conditions.

Swap-based (Funded structure)

In a funded structure, the ETF passes its cash holdings (pooled investors’ monies) to a swap counterparty. In exchange, the swap counterparty pays the returns of the index the ETF is tracking.

The swap counterparty will post collateral with a third party custodian. The collateral is held to offset the ETF’s exposure to the counterparty. The securities making up the collateral may be unrelated to the index the ETF is tracking.

Generally, collateral posted by the swap counterparty should reduce the funded ETF’s net exposure to the counterparty to not more than 10% of the ETF’s net asset value. In the event that the counterparty defaults on its obligations under the swap, the funded ETF will suffer a direct loss of the difference between the index value and the value of the collateral. The funded ETF could suffer additional losses if the collateral is liquidated under adverse market conditions. 

Access product-based

In an access product-based ETF, the ETF invests in participatory notes (P-notes) or other derivative products that replicate the performance of the index. This structure has been used for indices on restricted markets such as China or India. For example, participatory notes linked to a basket of Chinese A-shares may be purchased and held by the ETF. As such, the ETF would be exposed to the counterparty risk of the participatory notes issuer.

Risks specific to swap-based structures 

Risk  What it means
Counterparty risk If an ETF uses the swap or access product-based structure, you are exposed to counterparty risk. Therefore, if the counterparty defaults, you could incur significant losses even if the underlying index is unaffected. Your loss will depend on the ETF’s exposure to the swap counterparty.
Concentration risk This arises if the ETF is significantly exposed to a single swap counterparty or very few swap counterparties.
Conflict of interest This arises if the same financial institution (or its related party) takes on multiple roles as the manager, swap counterparty, index provider, and market maker of the ETF. If so, the possibility of conflict of interests arises.
Collateral risk If collateral is provided, there is a risk that the value of the collateral may decline after a default by the counterparty. Also, the composition of the collateral held may have no bearing to the investment objective of the ETF. There may also be difficulties for the ETF to enforce its rights to the collateral.

Risks specific to access products-based

Risk  What it means 
Counterparty risk If the access product issuer defaults, the NAV of the ETF may fall, even if the underlying index is unaffected. Your loss will depend on the ETF’s exposure to the access product counterparty.
Concentration risk This arises if the ETF is significantly exposed to very few access product issuers. In some instances, the ETF may be exposed to only a single issuer. 
Tracking error This may be greater for access products because the structure has potentially greater inefficiency. For example, access product commissions and maintenance charges may be levied on the ETF for each purchase or sale of the access products.  
Access products have limited duration Access products such as P-notes are of limited duration and may be settled automatically after a certain number of years after their issue. The ETF may be unable to renew the term of the P-notes it holds.
Conditions governing foreign access to restricted markets may change The access product issuer may lose access to the underlying shares or to additional shares. If additional shares cannot be obtained, the ETF cannot create more units. This may affect the price of units relative to the NAV.
Collateral risk If collateral is provided, there is a risk that the value of the collateral may decline after a default. Also, the composition of the collateral held may have no bearing to the investment objective of the ETF. There may also be difficulties for the ETF to enforce its rights to the collateral.

What fees and charges are there?

Find out about transaction charges like brokerage charges and clearing fees from your financial adviser or broker.

There are usually no sales charges for ETFs. However, certain charges are payable by all ETFs. These include fees that the fund manager, trustee and other parties charge to the ETF. Although these fees are paid by the ETF and not by the investor, they will increase tracking error.

Key questions to ask or considerations before buying an ETF 

ETFs differ in terms of complexity, investment objectives, strategies, risks and costs. When choosing an ETF, consider the following:

i) Your needs and investment objectives, personal circumstances and risk profile. 

ii) Find out more about the ETF you are considering:

  • ensure that the ETF’s investment strategies are in line with your own investment objectives
  • ensure that you understand all the risks (whether it is a cash-based or synthetic ETF) and are comfortable the ETF matches your risk profile
  • ensure that you are comfortable that the fund manager has the necessary resources, experience and skills to manage your investment. Check that both the firm and the individuals managing the ETF have a credible performance track record. However, do note that past performance is not necessarily an indication of future performance.

iii) Find out about alternative investment products and compare their risk-return profiles and features with the ETF introduced to you.

 

The above information is prepared in collaboration with the Association of Banks in Singapore, Investment Management Association of Singapore, Securities Investors Association (Singapore) and Singapore Exchange.