- understand the basics of ETFs
understand the structure of ETFs
know about the risks of ETFs
- know about the benefits of ETFs
- be interested to invest in ETFs
ETFs are open-ended investment funds that are listed and traded on a stock exchange
This module will help you understand the basics of ETFs, the structure of ETFs and the risks and benefits of this form of investment. You will also learn if it is a suitable product for you and if you should include ETFs as part of your investment portfolio.
- What are Exchange Traded Funds (or ETFs)?
- Risk-Return Trade-off
- Open-ended structure
- Swap-based ETFs
- Risks of Swap based Structures
- Why do people invest in ETFs?
- Are ETFs suitable for everyone?
- Investment strategies for ETFs
- Considerations before investing in an ETF
Learn how ETFs can form part of your investment portfolio to provide diversification benefits at a lower cost.
- Those who are interested in ETF investments
- working adults
Looking at the graph, the Straits Times Index (or “STI”) has gone up over the long to very long term. However, there is significant volatility, and investors may have incurred losses over the short to medium term. For a long term investor who is willing to ride out the volatility, investing in the STI could be a consideration. We can get exposure to STI through:
(1) an Exchange Traded Fund (ETF) or
(2) Unit Trust that benchmarks its performance against the STI or
(3) simply buying the 30 underlying component stocks of the STI.
What are Exchange Traded Funds (or ETFs)?
ETFs are investment funds 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.
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. Hence, index tracking ETFs have fees and charges that are usually lower than those of actively managed investment funds.
On the Singapore Exchange (SGX), there are two main categories of ETFs listed – physically replicated or cash based ETFs and synthetically replicated ETFs.
Investors buy or sell ETF units to gain exposure and participate in the performance of all the constituents in the underlying index.
All investments come with risk. The risk-return trade-off refers to an important investment principle: Investments that offer higher returns also have higher risks. There is no free lunch in investing. In other words, if you are not willing to take risks, you have to be contented with lower returns. Conversely, if you want higher returns, you must be prepared to bear more risks.
From the figure, we show how investment instruments can be ranked by their risk-return profile, starting with instruments that have both low expected return and low risk such as cash and deposits, and moving through to those with higher expected return but, correspondingly, higher risk such as stocks and shares.
The risk-return trade-off has a practical implication on investing. It is usually the case for us to put our focus on returns when considering any investment. The question to ask yourself before committing to an investment that can give potentially higher return is: “Can I afford to lose a significant amount of money?”
On the other hand, if your concern is risk, you may feel that a product that is capital-guaranteed may be suitable for you. Again, be aware of the trade-off as such products may offer lower returns. Some may not be suitable to hedge against inflation. You will also take a longer time to build up your savings.
When deciding on the appropriate level of risk for you, consider the following:
What is your investment horizon? Simply remember this: Do not take the risk if you do not have the time to recover from your losses.
What is your risk tolerance? Ask yourself: How much can I afford to lose?
Be extra prudent when investing your retirement savings.
The ETF has an open-ended structure which means the creation and redemption process depends on demand. The ETF fund size can expand as new units are created, or contract when units are redeemed.
It is this structure that allows ETFs to be less costly and more transparent for investors than traditional unit trusts.
The ETF, structured as a fund, owns the underlying assets (stocks, bonds, commodities), ETF investors do not have any direct claim to the underlying assets in the fund. Some have been categorised as Specified Investment Products, investors will need to a Customer Account Review (CAR) before investing in these ETFs.
On the Singapore Exchange (SGX), there are two main categories of ETFs listed – physically replicated or cash based ETFs and synthetically replicated ETFs. There are currently more synthetic ETFs listed than physically replicated ones.
Direct Replication or Cash-based ETF invest directly into the assets that make up the index. They may:
Invest in all of the index’s component stocks, bonds or assets in exact proportion. Or
Invest in a representative selection of the index’s component stocks, bonds or assets that reflects the profile of the index.
So it may hold assets not included in the index provided the holdings closely reflect the overall characteristics of the index.
Synthetic ETFs use derivatives such as swaps or participatory notes to produce returns which track the relevant indices.
The investor is exposed to the risk that the swap counterparty or access product issuer defaults on its payment obligations under the swap or access product. Defaults may occur if these parties become bankrupt or insolvent.
The amount of loss an investor suffers in such cases of default will depend on the ETF’s exposure to the counterparty or issuer.
Swap Based ETF
Synthetic ETFs that are swap-based may use either the unfunded or funded structure.
Swap-based (unfunded structure) When an ETF uses an unfunded structure, the ETF buys and holds a basket of securities. The basket of securities may be completely unrelated to the index the ETF is tracking. The ETF then enters into a swap agreement with another entity known as the swap counterparty.
The ETF will pay out the return it earns from the basket of securities to the swap counterparty.
In exchange, the swap counterparty pays the index’s return to the ETF.
The ETF holds and retains control of the basket of securities even if the counterparty defaults. In addition, the ETF’s exposure to its swap counterparty is usually limited to 10% of the ETF’s net asset value. This means the ETF could lose up to 10% of its net asset value due to unpaid obligations from the swap counterparty. Additional losses may still be possible, for example, if the basket of securities is liquidated under adverse market conditions.
Swap-based (Funded structure)
When an ETF uses a funded structure, the ETF passes its cash holdings (pooled investors’ monies) to a swap counterparty. In exchange, the swap counterparty pays the returns of the index the ETF is tracking. The swap counterparty will post collateral with a third party custodian. The collateral is held to offset the ETF’s exposure to the counterparty. The securities making up the collateral may be unrelated to the index the ETF is tracking.
Generally, collateral posted by the swap counterparty should reduce the funded ETF’s net exposure to the counterparty to not more than 10% of the ETF’s net asset value.
In the event that the counterparty defaults on its obligations under the swap, the funded ETF will suffer a direct loss of the difference between the index value and the value of the collateral.
The funded ETF could suffer additional losses if the collateral is liquidated under adverse market conditions.
ETFs provide access to different markets and asset classes
There are many ETFs to choose from. ETFs typically aim to produce returns that track or replicate the performance an index. If you buy an ETF which tracks a share index, you gain exposure to the performance of the index. For example, investing in an ETF that tracks the STI provides investors with exposure to the Singapore market.
What is an index? A stock market index is a representative sample of the stock market and is expressed as a single value to measure the relative value of the stock market.
If we are keen to invest in the US or China market, we can simply buy an ETF that tracks the Dow Jones Index or the Shanghai index respectively.
Similarly if we are keen on technology stocks, we can invest in an ETF that tracks a technology index.
Instead of investing in physical gold, for example, one can do so through an ETF that tracks a gold index.
Why do people invest in ETFs?
You can gain exposure to the performance of an index with a smaller sum compared to having to purchase individual stocks/constituents in the proportion of the index.
Investing in an ETF brings about broad diversification through a single transaction and less capital outlay than if you were to buy the constituent stocks to provide the exposure desired.
ETFs offer access to multiple market exposure, multiple asset classes via a single platform like SGX.
Through ETFs, an investor has access to markets or stocks that may be less accessible or restricted e.g. the China stock markets.
Lower transaction cost
As most ETFs are passive funds, the annual management fees are generally lower at less than 1% compared to unit trusts. There is also usually no sales charge, although any transactions in ETFs on the SGX would still be subject to brokerage commissions or transfer taxes associated with the trading and settlement through the SGX. However, the transaction costs and commissions will be lower for buying a single ETF that tracks the STI, compared to buying 30 stocks of the STI.
Market prices are published real-time throughout the trading day. As ETFs are traded on a stock exchange, you can buy and sell units of ETFs throughout the trading day. On the other hand, unit trusts are priced once a day and are not traded through an exchange.
The ETF has a net asset value (NAV), which is calculated at the end of each trading day. The NAV is published on the issuer’s website or SGXNET daily. It is used by investors only as a reference or an estimate. The price of the ETF is a function of the supply and demand of the ETF and is quoted at bid and ask prices like a stock. Hence the ETF may trade at a premium to the NAV if there is strong demand for the ETF.
Are ETFs suitable for everyone?
Investing in ETFs may not be for everyone.
They may not be suitable for you if you want potentially higher returns BUT are not prepared for variable returns which include the risk of losing all or a substantial part of your original investment amount; ETFs are not principal-guaranteed. The risks of investing in ETFs are described in the prospectus and product highlights sheet.
They may not be suitable for you if you do not understand how returns are determined or if you are unclear about the factors and scenarios that can affect returns;
Do you understand the risks associated with the ETF. Investors should be aware of the risks associated with the use of derivatives by ETFs, including the risk that the provider or counterparty of the derivative defaults.
Are you prepared to leave your money invested for long periods of time. A longer time horizon is generally preferred to ride out short term price fluctuations. But depending on the investor’s investment objective, some ETFs or inverse index products may be suitable for short term trading.
Are you familiar with the ETF manager and the ETF’s track record?
Investment strategies for ETFs
Investors can deploy ETFs for a wide range of investment strategies:
Active Trading - Investors could monitor and do active trading of ETFs.
Strategic allocation - buy and hold
ETFs have low management fees, which may be attractive for investors who adopt a buy and hold strategy.
Some investors may want a core investment portfolio to provide stability and long term growth and a satellite investment portfolio to target shorter term market investments with potentially higher returns (and risks). Diversified investments like ETFs may be suitable for some investors who wish to build a core investment portfolio.
Risk Management - Hedging or Shorting
Investors may use ETFs to hedge against other investment positions. For instance, an investor may short an ETF or purchase an inverse product against long stock holdings as a hedge against a decline in the market or specific sector.
Investors who have a negative view on a market segment or specific sector may establish a short position to profit from that view.
Considerations before investing in an ETF
ETFs differ in terms of complexity, investment objectives, strategies, risks and costs.
Before investing in an ETF, the investor needs to consider the following:
Ensure that the ETF’s investment strategies are in line with your own investment objectives.
Find out where and how you can get trading information on the ETF. Find out about the management company and ensure that you are comfortable that the fund manager has the necessary resources, experience and skills to manage your investment. Check that both the firm and the individuals managing the ETF have a credible performance track record. However, do note that past performance is not necessarily an indication of future performance.
Personal Risk profile
Know how high your risk tolerance is. This is the extent to which you are willing to see the value of your investments fluctuate and are even prepared for the possibility of losses. Do consider your ability to absorb or tolerate losses. If your tolerance is low, you could consider a broad-based lower risk ETF and accept the lower expected returns.
Determine how long your investment horizon is with reference to your life stage and other considerations such as liquidity needs. Sometimes a market can stay down for an extended period of time and it is important that you have the holding power to ride out the down market.
Considerations when selecting ETFs
The investor should consider the following when selecting ETFs :
Underlying asset class or index
Some investors consider the macro environment, from which the investor will then decide which asset class or index to invest in. For example, if the investor believes that the Singapore market offers good return, he will then look for an ETF that tracks the STI.
Another consideration is whether the index is too narrowly focused in a particular industry or geography which may not provide for diversification.
Size of ETF?
An ETF should be sizable as it is an indication of investors’ interest in that ETF. Strong investor interest will generally mean better spread and liquidity for the ETF.
Just as in stock trading, it is important to consider the trading volume of the ETF as trading volume is a good indication of liquidity. The more liquid the ETF, the more likely the spread will be better for the investor.
Structure and Risks
Is it a cash-based or synthetic ETF? If it’s a synthetic ETF, do you understand how the embedded derivatives are used and are you comfortable with the risks?
Find out about the ETF’s liquidity, dividend policy and fees and charges borne by an investor.
As discussed earlier, tracking error measures how closely the ETF tracks the underlying index. All things being the same, it is better to invest in an ETF that has lower tracking error compared to another with higher tracking error.
Current and expected market conditions
It is important to monitor market conditions as both market conditions and your personal circumstances change and may impact on your returns or investment objectives.
Do find out about alternative investment products and compare their risk-return profiles and features with the ETF introduced to you.
ETFs are investment funds listed and traded on a stock exchange. It typically aims to produce a return that tracks or replicates a specific index.
ETFs differ in terms of complexity, investment objectives, strategies, risks and costs.
Understand the risks and investment and assess if it is a suitable for you