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Are ETFs in Singapore Good Investment Options?

Background & Definition of ETFs
As at the end of May 2009, the global Exchange Traded Funds (ETFs) industry had 1660 ETFs with 3008 listings, with assets worth US$774.80 billion, from 90 providers on 42 exchanges around the world. Contrast this to a mere US$0.81 billion in assets of just 3 ETFs in 1993. The growth of the ETFs industry is astounding. In terms of market share, the five largest ETF providers in terms of asset under management are: Barclay’s iShares (US$374.96b), State Street Global Advisors, Vanguard, Lyxor Asset Management and Deutsche’s db x-trackers (US$28.26b).

In Singapore, there are 35 ETFs listed on the Singapore Stock Exchange (SGX). What exactly are ETFs? How do they work? Compared to unit trusts, are they good investment options?

ETFs are collective investment schemes (CIS) similar to unit trusts. A CIS is a security which pools investors money together so that the appointed fund manager can invest in a large number of securities. Unlike unit trusts, these funds are traded on the stock exchange. ETFs are traded throughout the entire trading hour. This is in contrast to unit trusts which are only traded once a day.

Moreover, most unit trust prices are only available at a future date. This is known as forward pricing. ETF prices are known immediately once a successful transaction is executed. Unit trusts are held by custodians appointed by the distributor which the unit trust is bought from. ETFs traded on the SGX are held by the Central Depository Pte Ltd (CDP) if the investor’s stock brokerage account is linked with it. Otherwise, the stock broker’s appointed custodian will hold the ETF. If any ETF is held in the CDP, any broker can sell this ETF as long as there is a linkage between the investor’s account with CDP. In contrast, a unit trust can only be liquidated from the distributor where the fund was originally bought from.

In terms of cost, each ETF transaction incurs a brokerage fee while each unit trust purchase incurs a sales charge. ETFs usually have a lower annual management fee than unit trusts.

The majority of the ETFs listed on the SGX are denominated in USD while the majority of unit trusts in Singapore are denominated in SGD. The difference in currency denomination should not be a concern to investors because foreign currency risk is related to the underlying investment and not the currency the ETF is denominated in.

An ETF usually can be sold short while this is not possible with unit trusts. In recent times, many stock exchanges have banned short selling and so selling an ETF short may not be possible for the time being.

Finally, the objective of an ETF is normally to replicate the performance of an index while the objective of a uit trust is to do better than an index.

Type of ETFs available in Singapore
A wide range of ETFs are listed on the SGX. In terms of single country equity funds, countries such as Singapore, India, Vietnam, Japan, China H Shares, Korea, Malaysia, Thailand and those invested in economies of Taiwan and Hong Kong are available. For those who prefer a more diversified equity exposure, regional funds such as MSCI World, MSCI Emerging Market and Asia are available. As for bonds, unfortunately there is only one called the ABF Singapore Bond ETF. For commodities, there is one gold ETF, one ETF that tracks the CRB and another one which tracks the CRB excluding energy.

ETFs can also be categorized according to the instruments used by the fund manager in meeting its investment objectives. There are 3 types of ETFs - note-based, swap-based and fund-based.

In a more note-based ETF, the fund does not invest directly into the securities concerned. Instead, the fund manager invests with one or more institutions through warrants, notes (or debt) or participating certificates. One reason for doing so could be due to foreign ownership restrictions in owning these underlying shares. The risk of such arrangement is the single counterparty risk. One example of such ETF is the rather popular iShares MSCI India (ticker I98) which has an average 3 months daily volume of nearly 1 million shares at the point writing. The prospectus dated 31 May 2006 on page 54 discloses that initially there is only one counterparty and that the fund credit risk of this single entity. As on 1 July 2009, this counterparty is Citigroup Global Markets Holdings.

Another type of ETF is swap-based. For such an ETF, the fund manager enters into a swap contract with counterparty. A swap is a series of cash flows based on some underlying. The exact mechanism of how a swap is used is beyond the scope of this article. A swap contract has a counterparty risk. There is always a possibility of the party defaulting on the cash flow outstanding. From my understanding, swap-based ETFs listed on the SGX has a default risk capped at 10% of the fund’s NAV. Swaps are used due to a variety of reasons such as improving tracking error, potentially reducing tax expense and access to markets that are difficult to invest directly. Investors will also need to consider whether they are comfortable with investing in swap-based ETF in which its swap counterparties are related entities with the fund manager.

Fnally, the last type of ETF is fund-based. Fund-based is traditionally the manner ETFs are based on. Swap-based and note-based are newer. For fund-based ETF, the fund invests directly with underlying securities. There is no known counterparty risk. The investor’s risk is the market risk exposure only. Due to their simplicity and lack of counterparty risk, fund-based ETFs are the preferred type of ETF recommended by financial advisers. However it appears that there are less fund-based ETFs being issued compared to swap-based ETFs. There are not many fund-based ETFs on the SGX. Those who would like to have a broader choice of fund-based ETFs will have to look at the ETFs listed in other exchanges such as London Stock Exchange, Swiss Stock Exchange. New York Stock Exchange and American Stock Exchange. On a personal note, my clients investments in ETFs are on both the London Stock Exchange and Swiss Stock Exchange.

Compared to UTs, are ETFs good investment options?
Most ETFs traded on the SGX are thinly traded. Some have no trades for a very long time. Others have market makers which stand ready to buy and sell from investors who wish to trade them. ETFs that have reasonable trading volume are street TRACKS’ STI, DBS Singapore STI ETF, iShares MSCI India, Lyxor Hang Seng, Lyxor Korean and Lyxor Taiwan ETF. Liquidity is important because you would want to be assured of the ability to sell your shares without resorting to selling them at a discount due to poor liquidity. Those ETFs with market makers can be assured that they will be able to buy and sell near the NAV. However, the commitment of these market makers in terms of th amount of shares they are willing to trade on a daily basis and the bid ask spread are not disclosed to the investing public. Thus, there is some uncertainty to the market making activity.

For unit trusts, investors are assured that the fund manager will trade once a day. However, this does not mean that unit trusts will guarantee to trade on every working day because there were instances when redemptions were suspended because the underlying securities were suspended from trading. Or those who prefer ETF that is more liquid, you will have to look outside Singapore.

One advantage of investing in ETFs is many investors have found that their actively managed unit trusts are not able to perform better than the index. To check whether your fund is doing better than the index, you just need to obtain the unit trust factsheet and compare its performance chart with its benchmark. This benchmark is the index for which the fund manager’s skill is measured against. There are many funds which have underperformed the benchmark. According to Standard & Poor’s Index versus Active Fund Scorecard for a five-year period ended 2008 (and with adjustment made to survivorship bias):

-63% of global equity funds underperformed the index;
-84% of international funds underperformed the index;
-59% of the international small cap funds underperformed the index;
-90% of emerging market funds underperformed the index;
-52% of high yield fixed income underperformed the index;
-79% of global fixed income underperformed the index;
-62% of emerging market bonds underperformed the index

The period ending in 2008 was particularly important because it closed with one of the worst stock market crashes. Yet, with so many active managers doing worse than the market, isn’t it a double whammy for investors to lose more than the overall market? If fund managers have been underperforming its own benchmark, would it not make sense to just invest in the benchmark? This is what an ETF does. Unfortunately, life is not as simple as it seems because not all ETFs are created equal. Counterparty risks embedded in some ETFs and liquidity issues continue to be of concern. Alternatively, investors can hire financial advisers to identify better performing unit trusts but investors have to identify financial advisers with fund manager-picking skills!

In Singapore’s context, distribution channels such as financial advisers, bancassurance and online portals are more familiar with unit trusts compared with ETFs. This familiarity also means that investors are able to obtain advice and information on unit trusts more readily. On the other hand, there are not many advisers competent to advice on ETFs. The distribution channels familiarity with unit trusts has to do with the remuneration because unit trusts pay commissions and trailer fees while ETFs do not. Investors who would like to invest in ETFs usually have to Do-It-Yourself (DIY) by selecting among the 1,660 ETFs and navigating the sea of choices and avoiding the unsuitable ones.

ETFs outside Singapore will require additional consideration for tax and estate planning. These topics are outside the scope of this article but they are by no means unimportant as their impact on the performance return of an ETF can be astronomical. When in doubt, consult your financial adviser.

iFast Financial, August 2009 to January 2010 edition.