http://biz.thestar.com.my/bizweek/story.asp?file=/2007/7/21/bizweek/18354968&sec=bizweek
Saturday July 21, 2007
Frustrated with the high cost of investing?
This is the second article of a four-part series by Bursa Malaysia on Exchange Traded Funds The worlds’ most heavily traded ETFs.
INVESTORS tend to own far too many stocks. They fail to realise the inherent risk and high investing cost that comes with this approach. Every industry from biotechnology, pharmaceuticals, telecommunications to financial services have alluring companies, all vying for your investment dollar. Your portfolio will eventually resemble the entire stock market if your strategy is to acquire market stalwarts of each sector. Any returns produced by this investing approach are encumbered by numerous transaction costs while a significant amount of time is required for record keeping and monitoring of each company’s progress.
This is when passive investing proponents argue in favour of tracking an index. The objective of this investment approach is to match the total rate of return on an underlying market (or asset class) or any segment of the market, as measured by an index such as the FTSE Bursa Malaysia Large 30 Index.
The main benefits of index investing is its low-cost, maintenance free structure, the broad exposure and diversification it instantly brings your portfolio which can be a stake in the entire market (via the country’s benchmark index) or specific segments or industries – large cap stocks, small cap stocks, bonds, biotech, energy, real estate investment trust and commodities.
There are two vehicles available for investors to invest in an index – an index fund or an exchange-traded fund. Index funds are more familiar in our market as they have been in existences for several years. You buy and sell these funds as you would with any unit trust funds. The key difference with index funds is substantially lower fees because a passive investing strategy does not require fund managers and their stock picking skills. (Take caution: Akin to bond funds, index funds should never cost as much as actively managed fund.)
What are Exchange-Traded Funds?
Now, think of an index fund that can be bought and sold on the stock market. This is the second vehicle known as an exchange traded fund or ETFs in short, which is used by investors to gain exposure to an index.
Exchange traded refers to shares that trade all day long and ‘fund’ describes hundreds or thousands of securities under one umbrella unified by a particular investment objective. In the past five years, this investment vehicle has been attracting billions of investing dollars in foreign markets and marketers continue to launch new ETFs as they find new indexes.
Global ETF assets surged from US$226bil in December 2004 to US$322bil in 2006. Interestingly, some of the world’s most popular ETFs have been trading under cute labels such as cubes, vipers and diamonds. (Refer to box story: The World’s Most Heavily Traded ETFs).
Why the Excitement over ETFs?
ETFs allow investors to focus on something that is extremely important: choice of asset class. There are ETFs that track performance of the entire stock market to various segments of it: large stocks, small stocks, energy, real estates investment trust – virtually any sector or industry of the market. There are ETFs that mirror the bond market (such as the first ETF in this country), even ETFs for commodities such as a recently launched ETF for gold which is backed by actual gold bullions stored in a vault. Pick an asset class that is publicly available for investing and there is a very good chance that it will soon be represented by an ETF.
While this sounds like something index funds can offer, ETF are a better fit for some investors because of its cost structure and flexible nature. Annual management fees can go as low as 0.9% of assets, which is much lower compare to the index fund management fee of 1.5%. The only other significant costs involved are brokerage fees, which is the same amount that you would have to pay to trade ordinary shares. This makes ETFs economical to buy and maintain over the long run, a trait that is especially attractive for the typical buy-and-hold investor.
The flexibility of an ETF comes from its listing on a stock exchange. Investors that acquire or sell an ETF can lock in its price instantaneously during trading hours. Traditional index funds like any other unit trust funds take orders during the day but the actual buy or sell transactions occur at the end of a trading day.
There is a common misconception about ETFs that should be put to rest. Unlike a share, liquidity of an ETF is not dependent on its average trading volume or the number of shares traded each day but more the liquidity of the underlying securities it is invested in. This is because the mechanism behind an ETF is far more complex than unit trust funds. A combination of players from brokers, financial institutions and market specialists work behind the scene as market makers for the ETF. Their role is to create or redeem ETF shares by using shares of the companies in its underlying index. This is beneficial to investors because it ensures a fair price for the ETF which is in line with its underlying net asset value.
Conclusion
The essence of an ETF, as with an index fund, is passive investing which downplays stock picking in favour of buying the market. As an investing tool, there is a lot an ETF can offer. It is easy and cheap to transact and provides instant diversification. In many cases, ETFs address specific market sectors that unit trust funds do not.
The worlds' most heavily traded ETFs
Nasdaq-100 Index Tracking Stock (QQQQ)
The ETF known as cubes (so named because of its QQQQ ticker symbol) trades on the American stock exchange and tracks the Nasdaq-100 index. This index consists of the 100 largest and most actively traded non financial stocks trading on the Nasdaq market. Because it eradicates the risk of investing in individual companies, QQQQ is used to invest in the long-term prospects of the technology industry. Between 2000 and 2004, QQQQ was by far the most heavily traded index fund.
Standard & Poor’s 500 Index Depository Receipts (SPDRs)
Spiders is the nickname of the first and largest ETF in the world. This ETF offers investors, a cost effective and hassle free approach to investing in the top 500 largest traded companies in the US, as it tracks the S&P500 index. Imagine the expense and effort required to individually acquire all 500 stocks that make up this index.
DIAMONDs Trust
Another ETF with a cute name is DIAMONDs. This popular ETF tracks the Dow Jones Industrial Average, a benchmark of 30 blue chip stocks selected by The Wall Street Journal. This index serves as a good barometer for the very large old-line American companies.
Vanguard Index Participation Receipts (VIPERs)
VIPERs are Vanguard’s brand of ETFs. Vanguard Group is a major mutual fund company with billions of dollars invested in various types of index funds. Their umbrella of products includes ETFs for many different segment of the market such as financials, healthcare or utilities.
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