Demystifying ETF Investments
For many individuals, an exchange-traded fund (ETF) is the most sensible way to invest in stocks, bonds, or commodities like gold.
When you buy shares in an ETF, you are essentially paying for the underlying assets in that fund. The ETF then trades like any other share in the stock market. You can enter into purchase and sale transactions at any time during trading hours.
An ETF has several distinct features that differentiate it from other similar financial products. One important characteristic is that it is a passive form of investment. An ETF does not try and outperform the index that it is tracking. It merely replicates the returns that the underlying asset makes.
This trait results in an ETF having a very low cost structure. The investment manager does not need to carry out research before deploying funds.
It is easy to understand how the investment process has minimal costs if one takes the example of an ETF that tracks a stock market index. The fund simply buys shares of a value that are in proportion to their weight in the index. This is a mechanical process that is easily automated. Consequently, only a small portion of your investment goes into fees and charges.
Not the same as a mutual fund
Although the idea behind a mutual fund and an ETF is similar, the two are very different types of investments. A primary dissimilarity is the way in which the two are valued.
Market forces determine the price of an ETF. While an ETF does declare its net asset value (NAV) at the end of each day, its market value could differ from the value of its underlying assets. This could happen if the price of one of its constituent assets changes during the day. Traders would spot this opportunity and buy or sell the ETF at a market determined price.
However, over a period of time, the market price of an ETF would reflect its fair value.
An ETF can be bought and sold on the stock exchange like a common share.
Mutual funds, on the other hand, can only be bought from the fund itself. Similarly, the only way that you can sell them is to redeem them with the fund. The transaction would take place at the NAV that the fund has declared.
ETFs that track the Straits Time Index
Both track the top 30 companies listed on the SGX-ST Mainboard. The returns that you can earn with either ETF will be very similar. This is because they track the STI as closely as they can. Due to this, the top holdings of both ETFs are almost exactly the same.
Top three holdings of the two ETFs
|Company||Percentage of assets under management|
|DBS Group Holdings||13.3%|
|Overseas-Chinese Banking Corp||12.7%|
|United Overseas Bank||10.5%|
Similarly, the remaining holdings of the two ETFs follow the exact pattern set by the STI. One big difference between the two funds is that the Nikko AM Singapore STI ETF was established relatively recently in February 2009. Because of this, its assets under management (AUM) are only S$176 million (figure as on 30 June 2017.)
The SPDR Straits Times Index ETF is of greater vintage and was set up as far back as April 2002. It had a comparable AUM of S$607 million.
Best performing ETFs
This list from Philip Capital, a prominent securities broker, provides an idea of the performance of some ETFs.
In the last one year, the best performing ETF has been the DBXT MSCI China ETF. It tracks the MSCI China TRN Index, the constituents of which include companies like Tencent Holdings, Alibaba Group Holdings, China Construction Bank, China Mobile, and Baidu. On an annualised basis, this ETF returned 9.9% over the last five years. Its performance in the last year has been spectacular with a return of almost 34%.
Another ETF that has provided a high return in the last year is the DBXT MSCI Korea ETF. This tracks the MSCI Korea Index, which has 112 large and mid cap Korean companies. While its one-year return is almost 31%, the 5-year annualized return is much lower at 6.8%.
Who should invest in an ETF?
The primary rationale for buying shares in an ETF is to invest in the underlying assets in a convenient and low-cost manner. For example, buyers of the SPDR Straits Times Index ETF would be effectively purchasing Singapore’s top 30 companies. If you are of the view that the country’s economy will continue to prosper, buying into an ETF that tracks the STI is possibly the most cost-effective and practical way to gain from this growth.
Just a year ago, the STI was at a level of 2,892. On 31 July 2017, the STI closed at 3,322, about 15% higher. Investors who had bought one of the two STI ETFs a year ago would have made a significantly high return.
But that is not to say that you cannot lose by purchasing shares in an ETF. If you buy a gold ETF and the price of the precious metal suffers a sharp decline, your principal would get eroded.
ETFs have become increasingly popular over the years. This product was launched by Vanguard’s John C. Bogle back in 1975. At that time, few thought that a fund that mimicked an index would hold any appeal for investors. Christened “Bogle’s folly,” the newly launched Vanguard Group’s First Index Investment Trust garnered only US$11.3 million.
The fund, which tracks the S&P 500, has since been renamed the Vanguard 500 Index Fund. As of 30 June 2017, its AUM totaled US$329 billion. The expense ratio is only 0.14%.
The success of ETFs is largely due to the fact that they have extremely low expense ratios. The SPDR Straits Times Index ETF has an expense ratio of only 0.3%, while the Nikko AM Singapore STI ETF’s ratio is 0.35%.
Investors have also realised that mutual funds, which can be viewed as an alternate to ETFs, often find it difficult to beat the index that they benchmark themselves against. In many instances, it is wiser to invest in an ETF that simply tracks the underlying asset.
In fact, John Bogle’s inspiration for the index fund came from economist Paul A. Samuelson, who was of the view that most stock pickers were unable to beat the index.
In an article written in 1974, he said, “But a respect for evidence compels me to incline toward the hypothesis that most portfolio decision makers should go out of business – take up plumbing, teach Greek, or help produce the annual GNP by serving as corporate executives.”