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Guide to ETFs: Understanding exchange traded funds

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29 Oct 2018 | 5 min. read

Find out how exchange traded funds (ETFs) work and what you should know if you are thinking of investing in one.

Key takeaways

  • ETFs are investment funds listed and traded on a stock exchange.
  • Many aim to track the returns of a stock or commodity index.
  • Many ETFs listed on SGX are complex structures involving the use of derivatives. Such ETFs are classified as Specified Investment Products

What it is

Exchange traded funds (ETFs) are investment funds that are 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.

How it works

An ETF typically aims to produce a return that tracks or replicates a specific index such as a stock index or commodity index.

Such index tracking ETFs are passively managed by ETF managers and do not try to outperform the underlying index. 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.

Note: Many ETFs have been categorised as Specified Investment Products (SIPs). You will need to meet certain requirements to invest in them. Check with your financial institution whether the product you are considering is an SIP.

Returns of ETFs

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.

What’s the most 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.

Why invest in ETFs?

There are many ETFs to choose from. If you buy an ETF which tracks a stock 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.

Here are a few advantages of investing in an ETF:

  • You can gain exposure to an index without having to invest in all its component stocks.
  • Fees and charges tend to be lower than for actively managed investment funds, as ETFs have lower management fees. There is also usually no sales charge, although if you buy and sell ETFs on the SGX, you would need to pay the applicable brokerage commissions or transfer taxes.
  • As ETFs are traded on a stock exchange, you can buy and sell units of ETFs throughout the trading day

Checklist

Are ETFs suitable for you?

Investing in ETFs may not be for everyone. Before you invest, make sure that you:

  • Want potentially higher returns BUT are also prepared for variable returns which include the risk of losing all or a substantial part of your investment.
  • Understand how returns are calculated and the factors that can affect returns.
  • Understand the risks associated with the ETF.
  • You should be aware of the risks associated with the use of derivatives by ETFs, including the consequences if the provider or counterparty of the derivative defaults.
  • Are prepared to have your money tied up 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 familiar with the ETF manager and the ETF’s track record.

What are the risks?

Common risks associated with ETFs include the following

Market risk


  • You are exposed to market risk or the volatility of the specific benchmark tracked.
  • For example, the performance of an ETF tracking the Straits Times Index (STI) will be directly affected by the price fluctuations of the component stocks of the STI.

Tracking error

  • Changes in an ETF’s 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 to keep up with market or weighting changes.
  • Execution costs, investment constraints, or timing differences may also add to tracking error.

Foreign exchange risks

  • You are exposed to foreign exchange risk if you buy an ETF whose base 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.
  • If the market maker fails to perform its duty, liquidity may disappear, making it difficult for you to sell your ETF units.

ETF’s traded price not reflective of NAV per unit

  • An ETF’s traded price may not reflect its NAV as the traded price is subject to market demand and supply.

Risks from securities lending

  • Assets held in cash-based structures may be used for securities lending.
  • You are exposed to the risk that the borrower of the securities defaults and does not return the securities.

Types of ETFs: Cash-based vs. synthetic

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 (or physical) 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.
  • 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 that 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 you suffer 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.

See also: How synthetic ETFs work

Tip

How to identify a synthetic ETF

On the SGX, synthetic ETFs are tagged with an ‘X’, which appears next to the ‘@’ used to mark SIPs. You'll see the symbols 'X@' beside the ETF's trading name.

Fees and charges

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.

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 affect your returns.

Checklist

Key questions to ask before buying

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

Do you know your own investment objectives?

  • Make a list of your needs and goals, personal circumstances and risk profile.
  • What investment objectives are you trying to achieve by adding ETFs to your investment portfolio?

Does the fund match your objectives and risk profile?

  • 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 with the ETF that matches your risk profile
  • Ensure that the ETF you are investing in fits in with your portfolio’s over risk-return profile and does not concentrate your exposure to certain risks

Are you comfortable with the ETF manager?

  • You should be satisfied that the ETF 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.

Have you compared it to other products?

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

Last updated on 06 Nov 2018