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Tea with Matthew Seah: Exchange Traded Funds (ETFs).

Tuesday, May 26, 2015

ASSI's most prolific guest blogger, Matthew Seah, readily agreed to contribute this guest blog when I asked him if he could do it. Such an obliging and intelligent fellow.

During the 4th “Evening with AK and friends” session, a young man mentioned cash-based and synthetic ETFs. After some discussion, AK shot an arrow for me to do a guest blog on ETFs, so here it is.

Firstly, exchange traded funds (ETF) are investment funds that can be traded on the stock exchange, hence the term ‘exchange traded’.

The main objective of an ETF is to replicate the performance of a basket of stocks of an underlying benchmark. An ETF is a passively managed fund and generally charge lower fees compared to actively managed funds. Hence the kind of returns you can expect from investing in an ETF is equal to the performance of the underlying benchmark minus management fees.

Alright! Now ETFs can be categorised into 2 broad types: cash-based or synthetic.
Synthetic ETF
Synthetic ETFs are more complex than cash-based ETFs. Synthetic ETFs creates a similar benchmark with the use of derivatives such as options, forwards, swaps and participatory notes. Like with all derivatives, synthetic ETFs are all Specified Investment Products (SIPs) on SGX.

As the use of derivatives are complex and often non-transparent in nature, MAS has kindly restricted trading of synthetic ETFs by requiring investors to go through customer knowledge assessment before they can trade synthetic ETFs.

Cash-based ETF
Cash-based ETFs are simple funds that allocate whatever capital pooled into the fund into a similar portfolio as the underlying benchmark. For example, the capital in Nikko AM STI ETF is used to invest in the 30 STI components stocks according to the weightage of each stock in the STI.

This is a preferred form for the safety seeking investor, as no third party credit risk is involved.

So what are the added risks involved in synthetic ETFs not found in cash-based ETFs?

Synthetic ETFs enter into contracts with third parties, or counterparties, when using derivative products. Hence there is counterparty risk where the counterparty might default on their obligations. Thus, your returns will depend on the ability of the counterparty to honour its commitments to the ETF.

With derivatives, leverage may be used to increase returns. While leverage may generate higher returns, it could also cause the ETF to lose more than the market.

Conflict of interest may occur when the counterparty and the ETF are from the same financial institution.

You can find out more about how ETFs are structured and their risks here.

How do I know if the ETF is synthetic or cash based?

Highlighted red is where you can determine if an ETF is synthetic or not. A ‘X@’ in the SIP column would indicate that the ETF is synthetic.

A ‘@’ indicate that the ETF is an SIP and customer knowledge assessment is required.

An empty box, i.e. ABF SG Bond ETF, indicates that the ETF is a cash-based ETF.

Why do ETFs use derivative products?
  1. Some markets like many emerging markets are inaccessible to the ETF, hence derivative products have to be used in order to gain access to the stocks.
  2. Derivatives when used properly, are hedging tools and can reduce risks and improve portfolio management for the ETF.

Lastly, as a result of doing some search for more information, I have found that the MAS
converted some ETFs, previously classified as SIPs, to excluded investment product (EIPs). The ETFs that were converted to EIPs will be predominantly cash-based and only use derivatives for efficient portfolio management including the hedging of risks.

Therefore, you would expect those with only a ‘@’ to eventually convert into an EIP under the new framework.

Here is the list of ETFs I found online:

"Following strong market feedback that earlier versions of the Specified Investment Products (SIP) regime had been overly broad, the Monetary Authority of Singapore (MAS) has tweaked its rules to exclude simple funds from the often cumbersome safeguards required to invest in more complex products.

"In a bid to encourage investments in exchange traded funds (ETFs), Singapore Exchange (SGX) will also waive ETF clearing fees from June 1 to Dec 31, 2015.

"Under the previous rules, products such as gold exchange traded funds and funds that invested in a particular country were treated the same way as leveraged products or those that tracked synthetic benchmarks. Under the SIP framework, investors who wanted to buy those products had to be assessed by their financial institutions for their ability to understand those products. A lack of competency or experience in understanding those products would require additional safeguards to be put in place before the investment could be allowed.

"But the new rules, which took effect on Wednesday, carved out exemptions from the SIP requirements for funds that trade in gold as well as those that use derivatives only for hedging or efficient portfolio management purposes."

(Source: The Business Times, 30 April 2015.)

Thank you, Matthew!

Related post:
The 4th Evening with AK and friends: A success!


SG Engineer said...

Hi AK71

On a unrelated note, could you comment on how is it that so many Singaporeans involved in money scam which is essentially criminal breach of trust involving tens of millions and seem to be able to get away scot free? I know these people planned ahead and moved out of the country, is there no law available to do something about them? Definitely there is a way to find out where on earth they live, perhaps name them and shame them globally? Publish their pictures may be?

Just a recap;

+Jan 2015 - Suisse International money scam by a family of Chow's, alledgely involving SGD 35 millions

In 2013, The gold guarantee by Lee ST, invloving 33 million

The CTL Property scam, also involving tens of millions..

I am just curious, at least find out where on earth these people are now, which is not difficult i believe if the government want to do, and tell them that they are "wanted" people, they will live in fear instead of enjoying high life with all their ill gotten money.

AK71 said...

Hi SG Engineer,

I share your sentiments. More should be done especially by people with the resources to do so.

There are many more examples of scams and I am sure readers could easily add quite a few to your list. -.-"

I always tell people that there are worse things than having lots of money "rotting" in our bank account. Nobody cares more about our money than we do.

Solace said...

A very good post to remind everybody that not all ETF are the same. Some are simply more complicated than the others.

While it is generally believed "ETF is a passively managed fund and generally charge lower fees compared to actively managed funds", there will be some exceptions, some ETF might have higher fee compared to their counterpart. Need to do some comparison.

Generally, i found the sales/management costs of ETF is still higher than some counter parts in US and Europe.

Hopefully, this can be improved further and it would be great if more ETF like VWRD,VWRL VT and VTI could come to Singapore :)

Xw said...

Hi Ak, any views on the china market? Do you foresee the music stopping anytime soon, which I think will affect all markets amd likely due to a major sell down...

Nearing its 5k target! What does ur crystal ball says?

AK71 said...

Hi Xw,

Unfortunately, I don't have a crystal ball, unless you are referring to my schizophrenic bowling ball. -.-"

For quite a while now, I am feeling quite secure in my well, not venturing out in the open. There could be a storm coming and I want to make sure that my well is well padded. Pardon the pun. ;p

jovan said...

Hi Matthew and AK,

Thank you both for your time and special thanks to Matthew who is going all out to write this up.

You have correctly mentioned about some of the things written however I personally think there are more to it. As such, for those who like to have a better explanation on why it synthetic (non-cash) ETFs are a concern. Please feel free to read this link up in details

Hope this helps :).

Thank you aka the guy whom raised this concerned.

ang said...

I've been wanting to venture into ETFs (other than the STI ETFs) but I'm put off by the liquidity... any comments?

AK71 said...

Hi Jovan,

We are always very happy when industry insiders share their insights and concerns with us. Thank you very much for making the evening a more enriching experience. I don't know about the rest but I certainly did learn something new. :)

Matthew Seah said...

Hi Jovan,

Thanks for your compliments and thanks for the link.
I omitted the more technical terms and made it simple for the readers to understand.
A more detailed web link is much appreciated.


Matthew Seah said...

Hi ang,

Indeed most ETFs are illiquid. It is so because of the EIP statuses that many ETFs have.

Do note that many of the ETFs have currency risks due to the fluctuations of foreign exchange.


jovan said...

Hi AK,

You are most welcome. In fact, we are all learning from 1 another as we can never learn everything in the universe. Knowledge is the way to go where I can see that you are trying your best to create a place for it. Seeing what you had done for the community as compare to what I did is nothing at all. I always admire you for always willing to share your knowledge objectively and openly :).

Kudos to what you have done and continue to keep up the good work.


AK71 said...

Hi Jovan,

Alamak. So paiseh. I have only been talking to myself. However, I do it in a variety of settings these days and not just in front of my PC. AK is mental and growing more so by the day. Cham. -.-"

Thanks for the encouragement. I hope I will not tire of talking to myself for many more years. ;)

In the meantime, please let me know if you would like to contribute a guest blog in future. I am always looking for knowledgeable people who don't mind writing an article or a few. ;p

jovan said...

Hi Matthew,
well said. With lots of the currency war going on, alot of the investor may face alot of problems on this. As such, at times I used UT for some of my countries specific investment as there's sgd hedge class. Of course course I'm paying a price for it due to the higher management cost n transaction cost. I think many investors today will face the issue of currency as alot of the time they need to make a bet them.

I remember donkey years ago, many bought USD at 1.7-1.8 range thinking that USD will never be down. So guess what happen now?

Hi Ak,
Haha thanks but no thanks. My ang mo bo ho, as such, i can't contribute much like you. however rest assured that that I will contribute by my comment in your blog if I can. Haha or should I say I need to be more active.

Kudos to both of you and please continue to do more for the community :)

Nick said...

Warren Buffett has repeatedly recommended index funds as the best solution for the average investor – whom he defines as nearly everybody.

Buffett revealed that when he passes away, the bulk of his wife’s estate would be placed into a single Vanguard index tracking fund, with the rest in government bonds.

Here is what he said:

My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s. (VFINX)) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions, or individuals — who employ high-fee managers.

Instead of listening to investment managers, says Buffett, investors – large and small – should instead read Jack Bogle’s "The Little Book of Common Sense Investing".

AK71 said...

Hi Nick,

Yes, a guest blogger, Solace, wrote about this before too:
Tea with Solace: Common Sense Investing.

SMK said...

index funds and etfs are different.

AhJohn said...

This question may divert to Matthew, I am looking at US S&P500 ETF, there are few counters, S27 at Singapore, VOO at US. Any view for share?
Some people prefer VOO, because of higher volume.

AhJohn said...

Some said only S&P500 ETF can really gain in long run, because US economy is dynamic enough, so always have great companies that over run the old economy ones. This may not happen in Singapore, Hongkong, banking always the big part of market.

Matthew Seah said...

Hi AhJohn,

S27 has low volume and is traded when the US market is closed. Hence you won't get great value buying or selling the counter.

VOO has lower expense ratio and thus would increase your overall returns compared to SPDR S&P500 ETF (SPY).

The US economy is significantly larger than Singapore's economy. The S&P 500 is also more diversified, comprising 500 companies, as compared to only 30 in our very own STI.


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