What is an ETF?
An exchange traded fund, aka ETF, is a type of investment fund that is publicly listed on the stock exchange. ETFs generally track indices, commodities, fixed income securities, or a variety of asset classes, depending on the mandate of the fund. In many ways, it is similar to mutual funds in pooling together funds from various investors to invest with a common objective.
What types of ETFs are there in the market?
There are many types of ETFs out in the market, but let’s focus on the main ones:
Market Index ETFs:
Market Index ETFs aim to track any specified market indices, with the objective of replicating the performance of the underlying market index as its benchmark. These indices may vary by their geographical location covered as well as the market capitalization of constituent companies.
Example: The SPDR S&P 500 ETF (SPY) benchmarks itself against the S&P 500 index, which tracks the top 500 US-listed companies by market capitalization.
Similar to market index ETFs, sector ETFs track a sector index which is representative of a specific industry, to emulate the performance of the underlying sector index. These sectors can vary according to the geographical location and industries covered.
Example: The Vanguard Information Technology ETF (VGT) tracks the performance of the MSCI US Investable Market Information Technology 25/50 Index, which is constituted of US companies within the information technology sector.
For most investors, bonds provide a relatively safe yet stable source of income, which thus makes bond ETFs a popular choice among ETF providers. Besides a steady stream of income, bond ETFs stand to offer better liquidity than direct holding of bonds due to its marketability on stock exchanges.
Example: The ABF Singapore Bond Index ETF (A35) tracks the iBoxx ABF Singapore Bond index, which constitutes of investment grade bonds issued primarily by the Singapore Government and quasi-Singapore Government entities.
Targeting only commodities, these ETFs provide investors with the investment exposure to desired commodities, from precious metals to agriculture. This allows investors to participate in the performance of such commodities without incurring significant costs (e.g. stamp duties, storage, security).
Example: The iShares Silver Trust (SLV) tracks the general price movement of physical silver.
How do ETFs track their underlying constituents?
There are 2 main structures of ETFs:
Physical ETFs: These ETFs replicate the holdings of the index they track through direct holdings in equal proportion.
Synthetic ETFs: These ETFs utilize derivatives such as swaps and options to replicate the indices they track.
How are ETFs priced?The value of an ETF is primarily determined by the Net Asset Value (NAV) of the fund. The NAV refers to the value per share of the fund’s underlying assets after deducting its liabilities. The NAV is therefore reflective of the fund’s value at the point of time the NAV was calculated. Nevertheless, the market price of the ETF may not always reflect its actual NAV as prices are subject to fluctuations as a result of market forces (supply & demand). As such, it is common for ETFs to be trading at a price above its NAV (premium) when the market expects the NAV to rise in the future, vice versa.
What returns do ETFs stand to offer?
Capital gains: A rise in value of the assets held under the ETF allow investors to gain from selling their shares in the ETF at a profit.
Dividends: ETFs with holdings in bonds and shares that pay dividends usually payout regular coupon and dividend payments to investors.
What are the fees and charges?
Brokerage Fees: As ETFs are listed on stock exchanges, brokerage fees apply to them as well, on a per transaction basis.
Management Fees: These fees are charged for the management of the fund to ensure accurate tracking of the underlying index through regular re-balancing.
What benefits do ETFs offer?
Diversification: Without requiring significant cash outlay, investors are able to benefit from diversification off their investments due to the diversified holdings of most ETFs.
Low-Cost: As most ETFs are passively managed, transaction costs incurred by the fund manager are minimal. Investors therefore benefit from these cost savings through significantly lower management fees.
Liquidity: Since ETFs are listed on stock exchanges, they available to the general public. This in turn provides liquidity and marketability for ETFs due to significantly higher trade volumes in stock exchanges.
Trading Flexibility: Since ETFs are bought and sold like shares, ETFs are similarly useful and effective to investors for trading purposes.
What are the risks involved in ETFs?
Market Risk: ETFs provide for portfolio diversification, which minimises unsystematic risk for investors. However, the assets held under any ETF are still subject to systematic risk in the form of price fluctuations due to market forces.
FX Risk: ETFs that are domiciled overseas or have holdings in overseas assets are subjected to fluctuations in their respective exchange rates.
Tracking Error: Depending on the consistency of rebalancing by management, ETFs may experience deviations in tracking the performance of their underlying indices. This is generally reflected in the beta of the ETF, which indicates the relative volatility of any asset (ETF) in comparison to the overall market (index). A beta of 1 indicates that the asset is perfectly correlated to the overall market with no tracking error.
Counter-party Risk: ETFs with holdings in coupon bearing bonds and dividend paying shares would be subjected to the risk of their respective issuers defaulting on payments.
Leverage Risk: Since ETFs are traded as stocks on public exchanges, margin trading can be used to produce higher-than-market returns. However, this also means that losses will be amplified as well.
How do I know if ETFs are suitable for me?
Depending on your risk profile and desired investment goals, ETFs can prove to be a vital part of any portfolio. Generally, ETFs are widely used as a long term investment due to its effectiveness in producing market returns over an extended investment period at a low cost. Please consult your financial planner to find out if ETFs are suitable for you.
How do I start investing in ETFs?
For SGX-listed ETFs, a CDP (Central Depository) account and a brokerage account will be required. For foreign-listed ETFs, only a brokerage account will be required. Please refer to our post on opening a CDP account for more information.
We hope that the above content has benefited you and will allow one to make a more informed decision in their investments.
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