Not all ETFs are created equally. Before investing in one, take a minute to understand the types of ETFs available in Singapore.
There are thousands of Exchange Traded Funds (ETFs) available in Singapore, and the options can be overwhelming. How can a product so simple end up being so confusing?
Don’t fret though. Here is a basic breakdown of what an ETF is, and what will be offered to you on the market:
What is an ETF?
An Exchange Traded Fund (ETF) is a basket of stocks, which imitates the movements of a particular market. The most popular ETF in Singapore, the Straits Times Index Fund (ST Index), closely mimics the movements of the ST Index. For example, if the ST Index moves up by 2.2 per cent, the ST Index Fund will also be up by 2.1 per cent (it will not be an absolutely exact match). If it moves down, the ETF will do likewise.
The main advantage of an ETF is that, unlike a mutual fund, there is no real “management”. A computer algorithm buys a collection of stocks that imitate the market, and that’s it. There is no “prediction” of what to buy or sell to make a profit. This makes ETFs a lot cheaper to buy into than actively managed mutual funds.
The other difference is that, as the name implies, units in an ETF can be bought and sold over a stock exchange. This is not the case with mutual funds, which have tight rules about when their units can be bought and sold.
What Types of ETFs are Available in Singapore?
Here are a few different types of ETFs, with their pros and cons:
1. Full Replication ETF
This is the most simple type of ETF. The fund purchases all the stocks in the index, in quantities according to weightage. As the index changes, the fund will buy or sell stocks to ensure it remains an accurate mirror of the index.
The main advantage of a full replication ETF is that it’s a “real” representation of the entire index. It is also quite simple for buyers to understand.
The drawback is that costs and tracking error (tracking error means incorrectly representing the market with the basket of stocks) are higher. It costs quite a bit of money to purchase every stock in the index, and there is more room for mistakes when trying to track thousands of stocks moving all at once.
Nonetheless, many traditionalists will insist that this is the only “real” kind of ETF.
2. Partial Replication ETF
Our local favourite, the ST Index Fund, is a partial replication ETF. It tracks the ST Index, but it does not hold every stock in the ST Index – instead, it holds only the 30 most capitalised (blue chip) stocks.
A partial replication ETF does not purchase every single stock in the ETF, because not all of these stocks are of significant weight. The argument is that only large, highly capitalised companies have stocks that truly move the index, whereas the tiny companies at the “tail end” of the market are negligible and do not move much. As such, it saves money to have the ETF track only the bigger companies’ stocks.
The main advantage of this kind of ETF is that it’s cost effective. The fund does not incur the multiple transaction costs from having to buy and sell loads of small stocks, which do not often contribute much anyway.
Detractors, however, argue that this is not an accurate representation of the index. In certain scenarios, partial replication ETFs can fail to duplicate market movements. One of these is a small cap led bull run – an event when the stock market as a whole rises on the back of multiple small companies, as opposed to a few big ones.
3. Synthetic ETF
These are quite common in Europe, but not so much in Asia or America. A synthetic ETF is not a “true” ETF at all and involves a counterparty. This is a little more complicated for regular buyers to understand.
Using this system, the investors pay the money to a third party. The third party uses the money to buy stocks in whatever portfolio it wants to build, but pays back the investors based on the result of an index. The portfolio built by the third party is used as collateral, in the event the fund implodes.
Does your head hurt? Don’t worry, here’s a simplified example:
Say you want to buy into our ETF, which uses the ST Index. This generates annualised returns of eight per cent per annum. When you buy into our ETF however, we don’t use your money to build an ST Index fund at all. Instead, we invest the money in our own way, and generate returns of 10 per cent per annum.
However, we will pay you the same returns that would have been generated, had you bought the ST Index.
The advantage to synthetic ETFs is the lack of tracking error. There is no actual purchase of any stocks in the index; the person(s) running the fund simply checks what returns the index produced, and then pay out the returns to the investors.
The downside is that many lay investors find this system confusing. It is, of course, a bad idea to invest in something you don’t understand.
There is also added counterparty risk, as there may be no guarantee that the counterparty can pay out the promised returns.
4. Inverse ETF
An inverse ETF (also called a bear ETF) pays out the reverse of the index. For example, if you have a reverse ETF based on the Hang Seng Index, and the Hang Seng is down 1.7 per cent, you will gain around 1.6 per cent. If the Hang Seng is up however, your returns will be down.
Unlike other ETFs, this is an exotic option used to “bet” against a particular market. If you feel the ST Index is going down, for example, you could purchase an inverse ETF pegged to it (assuming such a product is on offer at the time).
The returns are delivered through the use of futures and options, which are too complex to explain here. Suffice it to say it’s an ETF that delivers results opposite to its index.
The advantage of inverse ETFs is that, in bad times, they can be quite profitable. The more the index in question is down, the more you will make.
The downside is that, unlike other ETFs which are quite straightforward, this is more of a speculative tool. It is not meant to be held onto for the long term, and you must have good timing in choosing when to buy and sell. It is inadvisable for beginners.
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By Ryan Ong
Ryan has been writing about finance for the last 10 years. He also has his fingers in a lot of other pies, having written for publications such as Men’s Health, Her World, Esquire, and Yahoo! Finance.