Saturday August 4, 2007
Cost-efficient exposure to equities
As the number of ETFs in Malaysia is expected to rise soon, let’s discuss why and how to pick an ETF and how to use ETFs in an investment portfolio.
ETF advantages
From a strategic standpoint, ETFs can be quickly and easily used to assemble a broadly diversified index portfolio invested in major market sectors. Say, you are confident of India and China's growth prowess but are unwilling to take a bet on a specific share.
If there are ETFs that track each country’s benchmark index, they can provide that exposure along with instant diversification (because it holds a basket of securities that mirrors the benchmark index).
It is very unlikely that all companies will collapse at the same time. Then, execute the simple buy-hold strategy to ride on further development from these economic giants. It would be far more complicated to invest in individual stocks.
Low-cost investing
Perhaps the biggest advantage ETFs have over its index fund counterparts is their rock-bottom cost.
There are low fund manager’s fees to pay, giving most of your invested capital a chance to grow. The annual operating cost of an ETF is meagre, ranging around 0.12%.
Index funds, another passive investing vehicle that tracks an index, should also be cheaper than actively managed funds (those with a dedicated team of stock pickers).
If the ETF tracks less popular and widely-accepted stock themes, its annual expense ratio may inch closer to 1%, which is still substantially lower than the charges imposed by index funds in this country.
There is one caveat to remember: ETFs trade on an exchange, so you will need to pay brokerage commissions to buy and sell them, just as you would with stocks. The trading cost will pile up if your strategy is to trade in and out of the ETF frequently.
Flexibility
There is, however, an advantage to trading ETFs on the stock market. Acquisition and disposal is done during trading hours and investors can lock in a price for the ETF immediately.
If your ETF tracks a volatile market that suddenly starts tumbling, you can dispose of your investment during market hours, before the price of the ETF drops any further.
In a traditional fund, your sell order is transacted based on the fund’s net asset value at the end of the day, regardless of when you put in your order to sell.
Time efficiency
Many investors do not have the time to monitor the progress of individual stocks or to study the company’s annual reports.
Due to the diversity of its holdings, ETFs are ideal for investors who lack the time or inclination to select individual stocks.
ETF disadvantages
This is the same risk you face with stocks and unit trust funds. An ETF is not exempted from market risk and volatility as it replicates the performance of an index by investing in the same basket of securities and in the same proportions.
If the index performs well, the ETF is likely to do the same. If the index does poorly, the ETF's performance will be similarly affected.
Once you know exactly what the ETF is going to bring to your portfolio, stay away from excessive trading.
The ability to move in and out of ETFs quickly can lead to the temptation of jumping into markets or industries that you see poised for growth and bailing out when performance tumbles.
This is a great strategy in theory; but in reality, it is extremely difficult to execute. Investors tend to make the common mistake of buying into a ‘hot’ sector after prices have been pushed up, only to sell at a loss when prices start correcting.
From a cost perspective, frequent trading could eventually lead to the brokerage commission exceeding the fees imposed by index unit trust funds.
For these reasons, it would be wise to think like a long-term investor and view the ease and flexibility of trading ETFs as a just-in-case feature, only to be used when the market springs an unexpected and unpleasant surprise.
How to pick an ETF
In principle, an ETF is not any more complicated than its underlying securities. If you know enough about what it holds, you know enough to invest in an ETF.
To avoid the most common foibles, all you need is a little due diligence on its investments and exercise some trading restraint. If you believe its unique design and flexible nature can be leveraged on, here are some tips on how to pick an ETF.
Any time you are faced with a new product or a new asset class, go back to the asset allocation of your portfolio.
To be successful, investors must know the percentage each asset class should occupy. The importance of asset allocation cannot be overstated.
Many investors spend too much time and too much money picking individual stocks instead of evaluating what type of stock or fixed income instrument they should be holding.
After you have identified the key areas of exposure in your portfolio, such as a specific market, industry or stock type, then identify ETFs available to you.
Read up on the investment objective of each ETF and obtain its top 10 holdings or sector distribution to ensure it is invested in the industry or assets that you want.
ETFs must file annual or semi-annual reports on its investments. Refer to these reports and its prospectus during your research.
There may come a time when you find competing ETFs invested in similar securities. If this is the case, select the ETF with a lower expenses ratio as listed in its reports.
Once you have found an ETF that fits your overall portfolio there are numerous ways to maximise their advantages.
How to use ETFs in your portfolio
1. Gain exposure to the broad market
This is the most effective way of maximising an ETF.
By buying and holding an ETF that tracks the entire stock market, you immediately gain a diversified portfolio holding all the important stocks in the country.
You can apply the same concept for bonds and foreign investments. For example, the CIMB FTSE Asean 40 ETF listed on the Singapore Exchange tracks the FTSE/Asean 40 Index, which comprises the 40 largest listed companies across Malaysia, Singapore, Indonesia, Thailand and the Philippines, ranked by market capitalisation and free-float adjusted.
2. Filling up the gaps in your portfolio
You may already have investments that give you exposure to certain asset classes in your portfolio.
You can buy an ETF tracking the asset class that you desire, at lower cost and much less risk than buying a stock or an actively managed unit trust fund.
3. Going for specialisation
Want that extra special ingredient in your portfolio? There are more and more specialised ETFs rolling out all over the world. Earlier we talked about a gold ETF but there are many more.
Want property? Look for a real estate investment trust (REIT) ETF. Anticipate a booming healthcare industry? Acquire an ETF which holds pharmaceutical and health-related companies.
4. Stop-loss order
You transact your ETF through a broker or a remisier. This has the fringe benefit of setting a stop-loss order with the person you acquired the ETF from.
After specifying the price at which to sell, you can leave your ETF to track its index without having to monitor its day-to-day price movements.
Parting words
There is much to like about ETFs. As passive investments, they harness the power of the broad market without the risk of single-stock exposure. Granted, they will never outperform the market because their objective is to replicate its performance, less the ETF’s minimal expenses.
As an investment vehicle, ETFs are cheap and can be bought or sold at any time during market trading hours.
When ETFs start proliferating in our market, consider using them to cut back on fees that keep eating away at your capital and to fill up gaps in your portfolio – a simple and effective strategy that works for both the novice or near-expert investor.
