Investing in Exchange-Traded Funds (ETFs)

Investing in Exchange-Traded Funds (ETF)

As the term implies exchange-traded funds or ETFs are funds that are traded on an exchange like the Singapore Exchange (SGX).  However, before describing what they are and how they function, it is best to first discuss benchmark market indices.

1. Benchmark Market Indices

When it comes to tracking the performance of an entire market or segment of a market, investors tend to look at that market or segment’s benchmark index.  For example, the Straits Times Index or STI is the most recognisable benchmark for the Singapore stock market.

The STI comprises the 30 largest stocks listed on SGX.  The market value of these 30 is roughly two-thirds the market value of the entire market, hence the STI can reasonably be said to represent all Singapore stocks.

So, if the STI rises or falls, we can say that the Singapore stock market rose or fell.

Similarly, over in the US, the Dow Jones Industrial Average (DJIA) also comprises 30 stocks and it is widely recognised as representing the whole market.  The S&P 500 is another benchmark index which is commonly taken to represent the US stock market.  The S&P 500 comprises 500 stocks.

2.Uses of benchmark market indices

Other than give investors an idea of how a market or segment is performing, benchmark indices are used to evaluate the performance of funds which are invested in that market or segment.

In other words, a fund or unit trust which is invested in Singapore stocks will likely have its performance measured against an index like the STI or something similar, which could be the Morgan Stanley Capital International Singapore Index.

Similarly, a fund which offers exposure to US stocks could have its performance benchmarked against a US index such as the DJIA or S&P 500.

If the fund makes 15% over a period, then this will be compared with the movement of the index over the same period.  If the index rose 10% then the fund can be said to have “outperformed’’ the market.  If however, the benchmark rose 16%, the fund is said to have “underperformed’’ the market.

In other words, fund managers seek to beat their benchmark indices.

3. Can fund managers beat their benchmarks consistently?

This is an interesting question because most studies suggest that the answer is no.

Last year for example, a research team from S&P Dow Jones looked at all the 2,132 broad, actively managed domestic stock mutual funds that had been operating for at least 12 months as of June 2018.

The team selected the 25 percent of the funds with the best performance over the 12 months through June 2018.  Then the analysts asked how many of those funds remained in the top quarter for the four succeeding 12-month periods through June 2022.

The answer was none.

Another study in 2011 found that over the 23 years ending in 2009, actively managed funds trailed their benchmarks by an average of one percentage point a year.  If a benchmark like the S&P 500 returned 10%, the average managed fund investing in similar stocks would therefore have returned 9%.

Enter ETFs

Following from the above discussion, if the most – not all – fund managers are unable to consistently outperform their performance benchmarks, then why don’t investors who want exposure to a particular market simply buy that market?

This is why the ETF industry was born.

An exchange-traded fund or ETF is a fund that seeks to track a benchmark market index.  Such an instrument appeals to passive investors who are happy to simply “buy the market’’ instead of having to do research as to which fund is best, or to do stock selection on their own.

In order to “buy the market’’, they simply buy the index.

ETFs are listed on an exchange like the SGX and can track stocks, bonds or commodities like gold indices.  For example, there are two ETFs which track the STI that are listed on SGX.

Advantages of investing in ETFs

- Built-in diversification. ETFs may trade like stocks but they are closer to unit trusts in many respects, the most important resemblance being their highly diversified nature.  So if you buy an STI ETF, you are gaining exposure to a basket of the 30 largest stocks listed on SGX, which include banks, telcos, manufacturing and property stocks.

- Lower fees. Because ETF providers take their lead from the parties responsible for the index, there is no active stock selection involved.  As such, fees are typically lower.

- Transparency: When you invest in an index ETF, you know exactly what you are investing in. If the index constructors make changes to the index, the ETF provider simply rebalances its fund so that it continues to mimic the index.

- You gain exposure to the whole market for a small outlay.

Disadvantages of investing in ETFs

- They come with risk. ETFs are equity market products so they come with stock market risk, even though the underlying index can represent a diversified portfolio. Note that they are not capital-guaranteed.

- Tracking error. Although an ETF manager will try to keep their fund’s investment performance aligned with the index it tracks, that may be easier said than done.

An ETF can stray from its intended benchmarks for several reasons.  For instance, if the fund manager needs to swap out assets in the fund or make other changes, the ETF may not exactly reflect the holdings of the index.  As a result, the performance of the ETF may deviate from the performance of the index.

- Low liquidity. Since ETFs are favoured by passive investors who prefer to buy and hold, they may not be actively traded, resulting in low liquidity.

- Synthetic ETFs are riskier. Cash-based ETFs mean that the manager actually holds the assets in the index.  However, some ETFs are synthetic, which means the manager does not own the underlying assets and uses derivatives like swaps to replicate the performance of the index.  These arrangements introduce more risk into the equation, which means that synthetic ETFs are not suitable for retail investors.

Note:

For free and unbiased financial education on personal investing, you can visit the Institute for Financial Literacy (IFL). IFL provide talks and workshops to the public and do not promote financial products. Their financial education programmes cover basic money management, financial planning and investment know-how.

Disclaimer:

The information presented here is to provide general awareness and educational purposes and does not constitute specific financial or investment advice. Any mention of private or public organisations, reference to products or numbers used, are for the purpose of providing illustrations to help in understanding concepts being presented.

You are always encouraged to consult a licensed financial advisor, relevant government agencies and/or your family before making any major financial decisions.

Credit Counselling Singapore

Published 14 April 2023.