COVER STORY The Basics of Exchange-Traded Funds

Exchange-traded funds (ETFs) have become an increasingly popular investment vehicle in recent years. The attractions of ETFs include low cost, high liquidity and transparency. ETFs also offer investors a way to gain access to a wider range of markets and asset classes. In this short guide, we help investors understand the basics of ETFs.

1) What is an ETF? 3) What kinds of ETFs are available to investors? An exchange-traded fund, or ETF, is a fund that trades There are many different types of ETFs that are available on a stock exchange, just like an ordinary stock. There to investors. The most common ETFs are the ones are bid and ask prices quoted for ETFs during the trading which track the stock market indices such as S&P 500, hours of the exchange and investors buy and sell ETFs NASDAQ or MSCI Asia. But ETFs have also become in the same way as stocks. In contrast, conventional increasingly popular as a way for investors to gain funds, or unit trusts, are traded once a day, in some access to alternative asset classes such as currencies instances once a week or month, and the buying or and commodities. For instance, if you want to invest in selling price is usually only confirmed after the end of oil, you could buy an Oil ETF which has the objective of market trading hours. tracking the price of West Texas Intermediate (WTI). To deliver this objective, the ETF could be invested in WTI futures contracts. 2) Are ETFs managed actively or are they passive investment vehicles? ETFs were originally conceived as passive instruments designed to track an index. This differentiated ETFs from actively-managed unit trusts. For instance, if you were to invest in a China A-Shares unit trust, you would most likely be investing in a portfolio of China A-Shares stocks selected by a manager. The unit trust may have the SSE 50 Index as its benchmark but the selection of stocks is likely to be different from the benchmark as the manager would be attempting to outperform the index. In contrast, if you were to invest in an ETF whose underlying index is the SSE 50 Index, you would effectively be investing in the index as the composition of the ETF would closely track it. Now, while there are also actively-managed ETFs available to investors, these are still in the minority. The selection of securities in actively-managed ETFs could be done by a mathematical model, designed to mirror an existing unit trust or actively managed like a conventional unit trust. One reason why actively- managed ETFs are not widely available is because there is a technical challenge in creating them in such a way that does not open up opportunities for arbitrage.

FUND FOCUS JANUARY 2010 3 4) What are the advantages of investing in ETFs? 5) What are some of the risks in investing in ETFs? One main advantage of ETFs is that their costs are As with most financial instruments, there is normal typically lower because they are mostly passive market risk when investing in ETFs. This is the risk that investment vehicles. The management fee of ETFs is the underlying index or asset declines in value, and loss typically less than 1%1 per annum. However, because is incurred. An Equity ETF is exposed to the same set ETFs are traded on a stock exchange, investors would of risks as the equities it tracks. A Commodities ETF is have to incur charges like brokerage, trading and exposed to the same risk as its underlying commodity. clearing fees. There is a class of ETFs which is aggressively structured Another advantage of ETFs is liquidity. ETFs can be to provide multiple times the return of the underlying bought and sold continuously during the trading hours benchmark. These leveraged ETFs typically not only of the stock exchange because each ETF usually has include the securities of the underlying index but also a ‘market maker’, a financial institution which stands derivative products such as options and futures. While ready to buy or sell units. Investors appreciate liquidity leverage can multiply an investor’s returns, it can also when volatility in markets is high. magnify losses. An inverse ETF, on the other hand, is structured by using various derivatives for the purpose A third advantage with ETFs is transparency. With ETFs of profiting from a decline in the value of an underlying that track market indices, investors know exactly what benchmark. Investors who are looking at purchasing securities they are investing in since information about inverse ETFs want to position their portfolios against the composition of indices is easily available. falling prices. ETFs are also a low-cost way for investors to gain There is also the risk that the ETF manager may not diversification. To invest across a stock index by holding exactly replicate the performance of the underlying the actual shares would require a significant amount index or asset, and the ETF suffers from ‘tracking error’. of capital whereas with ETFs, as with unit trusts, Because of tracking error, the actual return of the ETF investors can gain the same benefits of diversification could diverge from that of its underlying index or asset, with a much smaller amount of capital. but the difference is usually not large. ETFs also offer investors a way to invest in markets In addition, there is a bid/ask spread risk with ETF. As which are restricted or not easy to access. There are ETFs are traded on an exchange, the buying and selling currently 37 ETFs2 listed on the Singapore Exchange, prices may include a premium or discount to the net the majority being equity-linked ones. Apart from asset value of the fund. The size of the premium or tracking popular indices like S&P 500, there are discount depends on the supply and demand for the ETFs which track indices for China A-shares, Vietnam, ETF. An ETF for which demand is strong may trade at a Russia and Latin America. premium. During periods of high volatility, it is also likely Aside from equities, ETFs are also increasingly popular that the bid/ask spread widens. as an investment vehicle for alternative asset classes, in Investors should also take into account counterparty particular commodities and currencies. These ETFs can risk when investing in ETFs. There are two broad classes be highly specific and track for example just the price of ETFs. One class is structured by cash replication, of corn, or the movement of the Brazilian real against a where the ETF is backed by actual securities such local currency. as physical gold or shares. Another class of ETF is structured through the use of swaps. With an Energy ETF, for example, the manager does not actually hold any inventory of oil but the ETF tracks the price of oil through WTI futures. In the event that the counterparty suffers financial failure, there is a risk that part of the holdings of the ETF becomes worthless.

1 Source: Singapore Exchange website, 23 December 2009 2 Source: Bloomberg, 23 December 2009

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