Exchange Traded Funds - SGX SIP Online Education Module

Exchange Traded Funds

• Investment fund listed on a stock exchange which give investors exposure to different asset classes like stocks, bonds and commodities.
  • Investment fund: invests the pooled funds of individual investors according to pre-set investment objectives. Through an investment fund, individual can afford to hire professional fund managers, achieve portfolio diversification, gain access to performance of a basket of instruments (such as constituent stocks of STI in the case of STI ETF), and lower expenses through economies of scale.
  • Asset classes: An asset class is a group of investments that have similar characteristics, behave similarly and are subject to similar market forces. Typical asset classes include equities (stocks), fixed income (debt), real estate, cash and commodities.
• They are passive instruments aimed at replicating the performances of an underlying index. They are not expected to outperform or underperform the index and would provide returns very similar to the perf of the index over the long run.
  • Index: An index reflects the movement of an investment portfolio. It is formed by a basket of securities or other assets like commodities and is calculated by aggregating the value of these instruments and expressing this against a base value.
  • The instruments that make up an index are known as index constituents. These are selected and maintained by an index provider such as iEdge, FTSE, MSCI and S&P.
• Buy/sell through a broker at market price throughout trading day
• NAV of an ETF: It reflects the fair value of an ETF unit, and is calculate as follows:
  • NAV per unit = (Total fund assets - total fund liabilities)/No. Of outstanding ETF units
  • While the NAV reflects the fair value, an ETF may at times trade at a price that differs from its NAV at a premium or discount

How ETFs track an index

ETFs in SGX-ST can be divided into 2 types. The difference in these two types of ETFs is the replication method used to track the performance of the underlying asset

Cash-based

1. Direct replication
   • The ETF directly invests in the same constituents and in the same proportion as the underlying index to closely track the performance of the underlying index.
2. Statistical or representative sampling
   1. The ETF invests in a selected number of constituents of the underlying index to track the performance of such index.
   2. This method is commonly used when the issuer wishes to employ physical replication but the index has too many constituents, making it difficult to acquire and manage the proportion of all the index constituents.

Synthetic

• Synthetic replication typically does not invest in the constituents of the benchmark index but involves the use of derivatives to replicate the performance of the index.
• An ETF that adopts the synthetic replication method may hold cash and/or a basket of securities that are not the constituents of the stocks of the underlying index and use derivates such as swaps to exchange the performance of the basket of securities with the performance of the index. It may also purchase derivates issued by a 3rd party such as participatory notes (p-notes) to replicate the index.
• SR allows issuer to minimise tracking error but that comes at a cost:
  • The ETF will be exposed to the credit risk of the swap counterparts and will be used by the issuer to exchange the performance of the assets for the performance of the underlying index
  • In the case of a default by the swap counterparty, the ETF will not be able to obtain the performance of the underlying index from the swap counter party
  • The extent of losses for the ETF depends on the exposure of the ETF to the counter party. If the exposure of the ETF to this swap counter party is 10%, then the max loss is 10%
  • However, the ETF still holds on to a pool of assets which generates performance used to swap for the performance of the underlying index

ETF Advantages

While ETFs and Unit Trusts are both managed by professional fund managers there are some key benefits for ETFs

1. Lower fees and transaction costs
   1. ETFs allows you to trade funds much like shares and at much lower costs than unit trusts
2. Transparency and tradability
   1. ETFs typically reveal their holdings daily
   2. With ETFs you can quickly enter and exit positions at any time during trading hours using rates that reflect real-time market conditions

Unit trusts: if you invest in a unit trust, your money is pooled along with other investors’ resources and are invested in a portfolio of assets based on the unit trust’s stated investment objective and investment approach. A unit trust is a fund that adopts a trust structure, but not all unit trusts have a trust structure

ETF Risks

Market Risk

• As with other securities, the underlying which the ETF tracks is subject to market volatility
• Change in market conditions will affect the price of the underlying, which constitutes the NAV of the ETF, leading to a change in price of the ETF

Foreign Exchange Risk

This occurs when

• Currency of actual assets held by the ETF differs from the denomination currency of the ETF
• Trading currency of the ETF differs from denomination currency of the ETF

Liquidity Risk

• Active trading of the ETF will not be maintained if the authorised participants or DMM ceases to perform its obligation to provide continuous quotes in the ETF
• The result is that the buyer may not be able buy and sell ETF in a timely manner at a fair price

Tracking Error

• Tracking error is a measure of how the value of the ETF may deviate from the value of the underlying which it tracks
• This may occur due to ETF management fees, transaction costs, replication methodology and cash holdings which do not yield any returns

Bid-Ask Spreads

• Bid-ask spread is determined by the difference of the price that a buyer is willing to pay for an asset vs. the price that a seller is willing to sell.
• Investors should note that there are scenarios such as market volatility or illiquid underlying which can cause the bid-ask spread to widen of the underlying to widen

---