A Guide to Exchange Traded Funds

Globally, Exchange Traded Funds (ETFs) are becoming an important asset class for both retail and institutional investors.  According to the World Federation of Exchanges, there are currently more than 600 ETFs worldwide with Assets under Management in excess of US$500 billion.   The growth of ETFs as a tool for trading and investment is seen across the United States and Europe, and they are slowly making their way into Asia.  What is an ETF?

What is an ETF?

ETFs are open-ended investment funds listed and traded on a stock exchange. They are managed by professional fund managers with the objective of tracking a specific benchmark, such as a stock index or a commodity price.  For example, iShares MSCI India ETF listed on the Singapore Exchange (SGX) aims to replicate as closely as possible, before expense, the performance of the MSCI India Index, while streetTRACKS Gold ETF aims to reflect the performance of the price of gold bullion, before expenses.  As ETFs are listed on the exchange, buying and selling an ETF is like any stock and you can transact with any stock broker.

What are the benefits and costs of trading ETFs?

ETFs offer several advantages.

Diversification and Efficiency:  Compared to stocks, ETFs on stock indices allow investors to avoid stock-picking by providing exposure to a diversified portfolio of stocks through a single transaction at an affordable price.  This will appeal to investors who may wish to adopt a buy and hold strategy with the hope of benefiting from potential long-term appreciation of their investments.  Furthermore, ETFs, being an index-based investment, offer diversification of unsystematic risk.   Unsystematic risk is the risk of price change due to the unique circumstances of a specific stock as opposed to the overall market. In addition, the index that the ETFs tracks, and therefore the ETFs, are automatically adjusted when any new major IPO is listed. For example, in the case of the Hang Seng China Enterprises Index (HSCEI), Hang Seng reviews the index every 6 months and with every major IPO like the ICBC Bank and China Merchants Bank, the index is revised. Therefore, investors get automatic exposure to changes in the index.

Compared to unit trusts, investing in ETFs is more cost-efficient as investors do not need to incur the typical sales charge of 3% to 5%.  The cost of trading an ETF is the usual brokerage commission similar to buying or selling stocks.  In addition, the annual management fee for an ETF is less than 1%, lower than the management fees for unit trusts which generally range between 1% to 2%.  You can invest in ETFs using cash and / or CPF.  Please refer to the CPF website www.cpf.gov.sg on the ETFs included under the CPF Investment Scheme.
 
Transparency and Flexibility: The process of buying or selling an ETF is transparent and flexible, just like trading stocks listed on the exchange.  Investors can access information on the ETF prices and trade ETFs throughout the trading day.  Moreover, investors can employ the traditional techniques of stock trading including stop-loss orders, limit orders, margin purchases, etc.  Such transparency and flexibility is not achievable with unit trusts as investors can only transact at one price calculated at the end of each day.
See Table 1 for a comparison of features between ETFs, stocks and unit trusts.

Table 1:  Comparison of features between ETFs, Stocks & Unit Trusts 

What are the risks associated with trading ETFs?

The risks associated with ETFs are similar to that of investing in stocks or unit trusts. 

Market Risk: Investors are exposed to market risk or volatility of the specific benchmark which the ETF tracks.  For example, the performance of the iShares MSCI India ETF will be directly affected by the price fluctuations of the constituent stocks within the MSCI India Index.

Tracking Error:  The fund manager of the ETF may not be able to exactly replicate the performance of the specific benchmark due to management fees, timing differences and other factors. This is known as tracking error. 

Foreign Exchange Risk:  For ETFs denominated in foreign currencies, investors should be aware that foreign exchange rate fluctuations may affect the returns.

Liquidity Risk: As in all investments, investors should be aware of liquidity risk – the risk arising from difficulty in buying or selling an ETF.  Liquidity in ETFs is usually provided by market maker who put up continuous bid-ask prices throughout the trading day.  As investors buy and sell an ETF, the market maker can create new units or cancel units to meet market demand and ensure that the ETF price is in line with the net asset value of the ETF.  This is possible because ETFs are open-ended investment funds with creation and redemption features. 

Conclusion

Before investing in an ETF, investors should understand the underlying benchmark exposure, its expected returns and volatility.  This should match with the investor’s risk appetite and investment horizon.  Investors should also read the prospectus and available research reports to help them understand more about the ETFs they are buying.  Here are ten things to consider before investing in ETFs.

Ten things to consider before investing in ETFs

1. Know your risk appetite
2. Consider your investment time horizon
3. Understand the underlying exposure – expected returns and volatility
4. Who is the Fund Manager & Market Maker?
5. Trading specifications – board lot size & currency denomination
6. Expected costs – brokerage commission & management fees
7. Check for other potential source of income eg. dividends
8. Compare with other investment options
9. Read the prospectus & available research reports
10. Attend an educational seminar.  To learn more about ETFs, visit the SGX website at www.sgx.com/etf and sign up for a free education seminar.

This information is provided by the Singapore Exchange Ltd (SGX) and the Monetary Authority of Singapore (MAS) as part of the MoneySENSE national financial education programme.