27 Oct 2018

Five benefits of ETFs

Exchange Traded Funds (ETFs) have grown in popularity over recent years. What are their features and benefits? The most distinctive feature is they do not try to beat the market – they do not attempt to outperform their chosen market index. They only seek to track the chosen market index so investors get a return that is close to what the index makes. Bear in mind, there may be small variations against the index’s actual returns – something called “tracking error”.

So, for example, if the ETF invests in Singapore stocks, then their chosen market index is the Straits Times Index (STI). The Singapore market ETF does not try to do better than the STI – they are structured to closely (not perfectly) track the index.

1. LOWER MANAGEMENT FEES THAN THOSE TYPICAL FOR UNIT TRUSTS:

ETFs bear significantly lower annual management fees because of this distinctive feature of not attempting to beat the market but to simply follow the market. So, they do not need to hire fund managers to “actively manage” the holdings. All they do is structure their stock holdings to closely mirror the performance of the underlying index. This is called “passive investment” and costs less than “active management.” Management fees will differ in different ETFs. But generally, they are significantly lower than for unit trusts. As an example, the Nikko Asset Management Singapore STI (Straits Times Index) ETF had an annual management fee of 0.2% last year. This was much lower than management fees charged by unit trusts, which are typically around 1% and sometimes more. But to be fair, this means investors are giving up the possibility of putting their money with a unit trust fund manager who may outperform the fund’s benchmark index. So, ETFs make sense where unit trusts available in your chosen market are not outperforming the benchmark index sufficiently to justify their higher fees.

2. UNLIKE UNIT TRUSTS, THERE ARE NEITHER INITIAL SALES CHARGES (SUBSCRIPTION FEES) NOR REDEMPTION (REALISATION) FEES FOR ETFS.

Unlike the situation with unit trusts, investors who buy ETFs on the SGX don’t pay initial sales charges. Nor do they pay redemption fees for selling their ETF units. An alternative to buying through a broker is investing via a regular savings plan. But for smaller amounts such as S$100, the sales charge is likely to be much cheaper than buying through a brokerage because it is common for brokerages to charge a minimum fee (often around S$25) for trades.

3. SMALL INITIAL INVESTMENT.

ETFs can typically be bought and sold on the Singapore Exchange (SGX) for board lots of 100 units. That translates into smaller initial investments than for unit trusts. For example, the ABF Singapore Bond ETF was trading at $1.117 at the time of writing – which translates to investments from as little as $112. Another example is the Nikko Asset Management Singapore STI ETF, which traded at $3.44, translating to investments as little as $344. Unit trust investments typically start at $1,000 although they can be much lower under a regular savings plan. However, the minimum brokerage fees mentioned above in #2 can be quite substantial in percentage terms for small amounts. So, in this instance, again, where investing in small amounts, it might be more cost efficient to buy ETFs through a regular savings plan.

4. DIVERSIFICATION FOR A SMALL OUTLAY.

For example, the SPDR Straits Times Index ETF holds 30 stocks to replicate the Singapore market index. That’s available at board lots of 100 units. And at a price of $3.39, that’s giving investors access to a small slice of a 30-stock portfolio for only $339.

5. REDUCING SINGLE STOCK RISKS.

So, it follows that if a retail investor was to start with only a few thousand dollars, the chances are he will only be able to start with one stock. That exposes the investor to “single stock concentration risk” – meaning he has put all his available investment dollars in one stock. And if something averse happens to that stock, the investor’s entire portfolio is affected. By investing in an ETF with 20-30 stocks, the impact of poor performance in any single stock is diluted.