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

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!