What is Exchange Traded Funds (ETFs)

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ETFs

  • It is an Investment Instrument – a stock market tool.
  • It tracks a bunch of securities’ prices.
  • Its value is pegged to the underlying securities’ price it is tracking.
  • It allows you to buy and sell hundreds of companies’ securities with just one purchase
  • It purchases individual securities based on a specific index’s composite and weightage. This is usually determined from their market capitalisation (the bigger the company, the bigger weightage the company will be on the ETF).

Benefits:

  • Tracks a basket of securities
    These funds tend to track a bunch of securities (stocks, bonds, commodities, etc).
    These funds can track general stock market index like the SPDR S&P500 (tracks the US S&P 500 Index) that consists of 500 biggest US companies listed on an exchange or track specific industries like Vanguard Financial ETF (tracks the financial institutions) that consists of 560 US listed financial companies.
  • Diversification
    One ETF tend to track many securities, like the above examples, which tracks hundreds of companies’ securities. This allows you to invest in many companies’ securities with just one security purchase.
  • Wide Investment Variety
    There are ETFs that track asset types like stocks, bonds (Eg; Government Bonds or Corporate Bonds) and commodities (Eg; gold or oil). There are also securities that allow you to invest in entire country’s stock market (Eg; China or India), specific sectors (Eg; Energy or Financials) and specific regions (Eg; Asia-Pacific or Europe).
  • Reduced Risks
    A large amount of securities in one ETF reduces the weightage and thus impact each company has on the ETF; which in turn reduces the risk posed to the ETF when one of the companies go bankrupt.
  • Low Capital Required
    To create a complete market-capitalisation-weighted portfolio like an ETF, it would require you to have hundreds of thousands of dollars to do it. Not all of us have that kind of money. However, with an ETF, you can essentially do it with just a few hundred dollars.
    Example: an STI Index ETF costs $2.78 per unit. A minimum board lot of 100 unit would cost your position $278, including a brokerage fee of $25, it cost a total $303; an amount that an average person most likely would be able to put aside to invest.
  • Less Hassle
    ETF fund managers, has numerous taskings in order to compensate for the management fees given to them. Their work range from helping you rebalance the fund (companies come and go, grow and shrink; so the ETF needs to change its weightage every once in awhile) to managing of dividends paid by the companies.
    It also allows you to avoid wasting precious time to read many companies’ annual reports to search for a good company to invest or spend time learning to learn a lot about investing. John C Bogle, founder of index funds once said, “forget the needle, buy the haystack”. An ETF investment allows you to buy just the haystack!
  • Low Cost
    All these benefits come at a good price – a low one in fact. The average ETF management fees per year usually cost less than 0.5% of your money, unlike the usual mutual funds that charges several percentage points or hedge funds which charges 20%. As Warren Buffett always say, a great investment is one that is well diversified and low in fees!
  • Decent Returns
    An ETF Index investing is like a tortoise way of investing especially if it is done like a savings plan – slow but steady! It tracks the market’s return (which average 9%-10% per year) and because of its low fees, allows you to keep most of that gain – which beats inflation.

Disadvantages:

  • An ETF may have tracking errors whereby it is unable to mimic the performance of the specific index due to changes in the weight basket of securities that the index is tracking. While on paper it is easy to change and monitor the performance of the different securities, in reality, ETFs face issues such as demand and supply of the underlying securities. An example: The STI Index decides to remove Capitaland from its index and replaces it with City Development. While the index can instantaneously effect the change, the ETF has to slowly sell its Capitaland shares and re-acquire City Development shares, based on market prices. As such, it requires some time to track the new index.
  • An ETF may also use leveraging to acquire its underlying securities and as any company, if it over-leverages and the market pricing is unfavourable to it, it might face a issue of insolvency. Hence, it is important to monitor the financial health of the ETF fund.

An ETF gives you plenty of flexibility in your investment strategy, both passive or active. You can employ them to build your retirement portfolio or use them as a bet on certain sector or region.

Investment Strategies:

  • Passive ETF Investment Strategy – Buy & Hold
    This is usually done with a general stock market index fund (like a STI Index ETF that tracks Singapore market or a global stock market ETF like the Vanguard Total World Stock Index).
    The strategy here is to accumulate these units over time, similar to your savings plan where you set aside a sum of money every month to invest in the ETFs.
    This allows you to dollar average out your position and allows you to buy more units when the price of the ETF has fallen.
    This also removes the need for you to time the market because this is the hardest thing to do in investing – even by professionals. Based on statistics, more than half of the professional fund managers are unable to beat the market returns. Coupled with excessive costs, they are less likely to match the market’s performance, hence, making this strategy attractive.
  • Active ETF Investment Strategy – Sector/Country Investing
    There are certain sectors that tend to perform better than the others during certain economic cycle. There are also certain sectors that are the rising stars of tomorrow such as clean energy and social media.
    Instead of picking individual stocks in these sectors, you could through an ETF (clean energy ETF, Financial ETF, etc) buy the entire sector and stand to earn good returns when they outperform the overall market.

You could even choose to invest in countries if you like by buying the specific countries’ Index ETF. There is the Hang Seng Index for Hong Kong, Nikkei for Japan or even the Shanghai Stock Exchange Composite Index which tracks the stock market of China.