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

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

What are the risks?

Common risks associated with ETFs include the following

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

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.