On ETFs: Understanding what it is about
As part of our financial weekly column I shall be collating a series of articles and facts that I have gleamed through the internet about, and crystallize the content in posts like this. Today, our first post will be on ETFs.
What Are ETFs?
In the simplest terms, Exchange Traded Funds (ETFs) are funds that track indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds is that ETFs don’t try to outperform their corresponding index, but simply replicate its performance. They don’t try to beat the market, they try to be the market.
ETFs have been around since the early 1980s, but they’ve come into their own within the past 10 years.
ETFs combine the range of a diversified portfolio with the simplicity of trading a single stock. Investors can purchase ETF shares on margin, short sell shares, or hold for the long term.
Net asset value (NAV) of ETFs
The NAV of an ETF reflects the fair value of an ETF unit. It is calculated as follows:
NAV per unit= (Total Fund Assets-Total Fund liabilities)/(Number of outstanding ETF units)
NAV is calculated once at the end of each trading day and published daily. However, since ETFs are listed securities, they are traded at market price rather than the net asset value.
The traded price of an ETF may deviate from its NAV due to demand and supply situation in the marketplace.
Apart from the end of the day NAV, most ETFs provide an indicative NAV calculated periodically throughout the trading day. The indicative NAV is sometimes known as IOPV (Indicative Optimised Portfolio value).
In the next post, I will be sharing on the risks and benefits of ETFs and how to buy one.
On ETFs: Benefits and how to buy one
As part of our financial weekly column I shall be collating a series of articles and facts that I have gleamed through the internet about, and crystallize the content in posts like this. Today, our follow up post will be on ETFs.
ETFs for Passive Management
The purpose of an ETF is to match a particular market index, leading to a fund management style known as passive management. Passive management is the chief distinguishing feature of ETFs, and it brings a number of advantages for investors in index funds. Essentially, passive management means the fund manager makes only minor, periodic adjustments to keep the fund in line with its index. This is quite different from an actively managed fund, like most mutual funds, where the manager continually trades assets in an effort to outperform the market. Because they are tied to a particular index, ETFs tend to cover a discrete number of stocks, as opposed to a mutual fund whose scope of investment is subject to continual change. For these reasons, ETFs mitigate the element of “managerial risk” that can make choosing the right fund difficult. Rather than investing in a fund manager, when you buy shares of an ETF you’re harnessing the power of the market itself.
Cost-efficiency and Tax-efficiency
Because an ETF tracks an index without trying to outperform it, it incurs fewer administrative costs than actively managed portfolios. Typical ETF administrative costs are lower than an actively managed fund, coming in less than .20% per annum, as opposed to the over 1% yearly cost of some mutual funds. Because they incur low management and sponsor fees, and because they don’t typically carry high sales loads, there are fewer recurring costs to diminish your returns.
Passive management is also an advantage in terms of tax efficiency. ETFs are less likely than actively managed portfolios to experience the trading of securities, which can create potentially high capital gains distributions. Fewer trades into and out of the trust mean fewer taxable distributions, and a more efficient overall return on investment.
Efficiency is one reason ETFs have become a favored vehicle for multiple investment strategies – because lower administrative costs and lower capital gains taxes put a greater share of your investment dollar to work for you in the market.
Flexibility of ETFs
ETF shares trade exactly like stocks. Unlike index mutual funds, which are priced only after market closings, ETFs are priced and traded continuously throughout the trading day. They can be bought on margin, sold short, or held for the long-term, exactly like common stock. Yet because their value is based on an underlying index, ETFs enjoy the additional benefits of broader diversification than shares in single companies, as well as what many investors perceive as the greater flexibility that goes with investing in entire markets, sectors, regions, or asset types. Because they represent baskets of stocks, ETFs, or at least the ones based on major indexes, typically trade at much higher volumes than individual stocks. High trading volumes mean high liquidity, enabling investors to get into and out of investment positions with minimum risk and expense.
Long-Term Growth of ETFs
It was in the late 1970s that investors and market watchers noticed a trend involving market indexes – the major indexes were consistently outperforming actively managed portfolio funds. In essence, according to these figures, market indexes make better investments than managed funds, and a buy-and-hold strategy is the best strategy to reap the advantages of investing in index growth.
How Do Indexes Work?
A stock market index is a list of related stocks, together with statistics representing their aggregate value. It is used chiefly as a benchmark for indicating the value of its component stocks, as well as investment vehicles such as mutual funds that hold positions in those stocks. Indexes can be based on various categories of stocks. There are the widely known market indexes, such as the Dow Jones Industrial Average, the NASDAQ Composite, or the S&P 500. There are indexes based on market sectors, such as tech, healthcare, financial; foreign markets; market cap (micro-, small-, mid-, large-, and mega-cap); asset type (small growth, large growth, etc.); even commodities.
Risks involved for ETFs
Although most of the market gurus out there are busy promoting the use of ETFs, the following risk factors remain something that most buyers should not underestimate. I have since summarized them under a table as seen below:
|Market Risk||The day-to- day potential for an investor to experience losses from fluctuation in the prices of underlying securities/assets.|
|Tracking error||The ETF fund manager may not be able to exactly replicate the performance of the underlying budget.|
|Counterparty risk||Some ETFs may use financial derivatives (eg: Swap arrangement with a third party) to achieve its investment objective.If any counterparty fails to perform its obligations under the derivative transition, the ETF may suffer losses.|
|Liquidity Risk||The market maker may be the only participant that is buying and selling the units and there may be circumstances where investors may not be able to buy or sell the units at prices desired.|
|Foreign Exchange Risk||Investors may be exposed to fluctuations in foreign exchange rates which increase or erode investment returns on the ETF.For example, if the ETF is denominated in USD and the assets in which the ETF holds are denominated in a currency other than USD, the investor is exposed to fluctuation in foreign exchange rate between USD and this currency.|
Cognizant of these potential risks, the investor must thus learn to weigh his or her own options before investing into a particular STF. For those without substantial capital upfront, they may want to buy into the STF via the method called dollar cost averaging.
What is Dollar Cost Averaging?
According to Investopedia, Dollar Cost Averaging is the technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.
It is helpful as increased purchase of the security would allow the average cost per share of the security to become smaller and smaller. Dollar-cost averaging lessens the risk of investing a large amount in a single investment at the wrong time.
So how should one go about implementing Dollar Cost Averaging Method?
1) Decide and set aside a sum of money at every regular period for the purchase of the ETF. Make sure that you are financially capable of setting aside this amount of money as this plan requires consistency.
2) Decide on how long that period should be. Do take note that the period should not be too long apart as this will decrease the effectiveness of averaging the cost of the investment. A suggestion would be every 2 to 3 months although that will depend on how much money you are willing to set aside.
3) At every regular interval, use the amount of money that you have set aside to purchase the ETF. It will be advisable to choose a fixed date at every regular interval to carry out the purchase. For example, one can choose the 1st day of every month or the day which your pay is credited into your account.
For example, the period that I have choose will be a 3 months interval. Assuming I am willing to set aside $1500 per month for the purchase of the STI ETF, I will have $1500 * 3 = $4500 for each period.
Picture this scenario: Assuming that the ETF is trading at $1.70. Since I have $4500 to begin with, I can buy 2 lots of STI ETF at $3400. Assuming the commission cost $30, I would have spend a total of $3400 + $30 = $3430. Thus I will be left with $4500 – $3430 = $1070 which I will accumulate over to the next period.
So, in the second period, let’s say that the STI ETF is trading at $1.40. Since I have a total of $4500 + $1070 = $5570, I can buy 3 lots of STI ETF at $4200. Assuming the commission cost $30, I would have spend a total of $4200 + $30 = $4230. Thus I will be left with $5570 – $4230 = $1340 which I will accumulate over to the next period.
In the 3rd period, assuming that the STI ETF is trading at $2.50. Since I have a total of $4500 + $1340 = $5840, I can buy 2 lots of STI ETF at $5000. Assuming the commission cost $30, I would have spend a total of $5000 + $30 = $5030. Thus I will be left with $5840 – $5030 = $810 which I will accumulate over to the next period.
Combining the 3 periods, you would have bought a total of 2 + 3 + 3 = 7 lots using a total of $3400 + $4200 + $5000 = $12600. Thus the average purchase price for one lot of STI ETF will be $12600 / 7 = $1800.
In this way, you will be able to average out the purchase price of the STI ETF and reduce the risk of putting all your capital at the peak of the market. You will also be able to achieve a positive return for the STI ETF if you are willing to hold the STI ETF since the STI will rise in the long run.