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!

Should I sell my investment to lock in gains? A perspective.

A conversation with a reader:

Reader says...

Thank you for a great post again, this time with the Singapore Savings Bond, you always have a clear way to put it - your opinion vs general and helps people like me to make my own decision. 

I've been your blog reader for few years, and haven't written or comment at your blog for a while. 

I had bought into some Singapore Reits over the years for passive income, and this email I'd like to seek your sharing of experience in "selling" of Reits. 

I have a long term view for Reits, and keep it for income, but this particular one is putting me to a spot now - sell now or hold. First Reit. 

I bought it at around $1 and it has now appreciated to 40% and DPU is consistent for past years, they have further acquisitions and developments in Indonesia in upcoming future.  





But at this stage, at a capital appreciation of more than 40% , I'm considering if I should sell it off because I made this rough computation in my head as: 

with a 8% yearly dividend yield, if I sold off at 40% capital appreciation, it covers the next 5 years of dividend, and if crisis comes within these 5 years, I could then buy it again and accumulate again as passive income (provided all else remains equal that it is still a good company to invest in). 

But then questions put me at a stop - what if price never falls any much lower, how to calculate the $$ value of both options - hold and collect dividend vs sell off and buy back later at x $ price. 

Last week I met a several people at the AGM sharing about such problem or challenge in making decision - how to decide to hold and collect the dividend or take in the capital appreciation and put in the money somewhere else? 

A senior guy for e.g had bought in Ascendas when it was $0.60 and sold off at $1.50 and never imagined it would raise up to over $2 now. so he has no conclusion or idea why and when to hold or sell of a Reit. 

hope to hear more of sharing your experiences of strategies to sell and take in profit, and thank you in advance, for time to read this long post. :) 

AK says... 

Always question our motivations. 

Are we investing or are we trading?




If we are investing for income, if the investment is still doing the job we expect it to do, generating attractive income for us, then, there is really no reason to sell unless we feel that there is another investment out there that can do a better job.

As for wondering if the market will crash in the next 5 years, no one knows for sure. 

That is in the realms of speculation.

In the meantime, income generated from my investments fill my war chest. 




If there should be a meaningful decline in prices, all else remaining equal, I will be able to load up using my war chest.

Of course, for people who mix investing and trading, if a stock is up from $1 to $1.50, for example, they could consider selling two thirds of their investment to recover their capital. 

Their remaining position is free.

Don't mind me. I am just talking to myself.





Now the reader will start talking to herself. It is a contagious disease:

Reader says... 

Thank you AK for the response! 

I can always trust you to put it in clear steps and points. now my brain is able to do some talking to myself, after what you talk to yourself :D 

looking forward to your posts.

Related posts:
1. When to BUY, HOLD or SELL?
2. A simple way to a double digit yielding portfolio.
3. Singapore Savings Bond: Good or not?
4. Do not love unless it is worth the loving.

So, you want to be financially free too but wonder how?

This blog post is really written with one person in mind. OK, there could be others like him. So, it is written with him and his like minded buddies in mind.



On 17 May, I shared the following on my FB wall:

Someone who was introduced to my blog wrote to me to say that it is difficult to have enough savings for investment as his salary increments will at most keep pace with inflation.

Of course, I gave him the usual talk on wants and needs but he said that he couldn't reduce his expenses for various reasons. (AK doesn't really believe this but close one eye lah.)

Anyway, he felt depressed after reading my blog. Alamak!

Save 100% of your take home pay. What?

So, cannot reduce expenses, how? I asked him to read Chapter 3 of this free "e-book".

I could have just given him the link to that single relevant blog post but I want him to read these 7 chapters (i.e. blog posts) together. Yes, AK is sneaky.

Don't depend on wage increases for higher income.



Journey to financial freedom is not a race.

Yesterday, this person contacted me and said he has read the "e-book" and he thinks that people like me are just "plain super". He didn't think he would be up to the challenge. He was wondering if there were easier ways available. So, what's new? Duh.

I know that it always is the hardest at the beginning. This is true. However, it will get easier over time. This is also true. It is whether we have the courage to take the first step and the determination to continue putting one foot in front of the other. It is a journey. Nothing is going to change if we stay at the same spot, feeling too fatalistic to make the move.

Many people have told me that my blog has changed the lives of many people for the better. It is just that I don't know about them as most people are not as talkative as I am. It was only in the last 1 or 2 years that many more readers have come forward to share their personal stories of transformation with me. I am glad.

I would like to do something for this person who is still feeling depressed and others like him. I would like to share bits of several chats I had with another reader in FB in recent weeks:

From what I know, W is someone who has parents and young children to care for. I believe that his financial burden is not light but he has the courage and determination to take the necessary steps to improve his financial health with an eye on generating passive income to help supplement his earned income. 

His is a story of a hardworking ordinary Singaporean who wants and is working towards a better life for himself and his family.

Some people say that the grit that Singapore's pioneer generation had is barely visible in the Singaporeans of today.

They say that the "can do" attitude is dying. They say that Singaporeans are spoilt and have grown soft. There is some truth in all the statements but we have a choice.

We have a choice to prove them wrong.

W has made his choice.

You have to make yours.

Related posts:
1. AK's birthday wish was for everyone to be wealthier.
2. "I used to think that the PAP was eating our money."
3. Tea with Matthew Seah: POSB Invest Saver account.

Should he do a VC or a MS Top Up to his CPF?

E-mail from reader:

Hello AK,

Hope this finds you well.

Firstly, thank you for sharing your knowledge with the readers! 

Been reading up on your blog posts since last year to improve my financial literacy and I have gained a lot.





Just a short introduction, I am 20 this year awaiting for my enlistment to NS. 

I intend to settle down at the age of 28 and hence, would need to save up quite an amount to afford for the wedding and a HDB flat. 

After reading your blog, I decided to make voluntary contribution to my CPF account starting next year to prepare for a sum of money. 

For example, contributing to OA from age 21 to 28 and thereafter, contribute to the SA till I retire which I aim for it to be at 55 years old.





Can you share with me your opinion on this plan of mine as I want to cover any loopholes as much as possible in my planning. 

Also, is it possible to just make a voluntary contribution to a specific account such as OA and not to all 3 accounts? 

I tried searching for the information on the CPF website but it was quite difficult for me to navigate around it.

Thank you for taking time out to read this and I look forward to your future blog posts!
Regards,N

Money tree? I go for low hanging fruits.

My reply:

Hi N,

Welcome to my blog. :)

Using cash, you could choose to do either a MS Top Up to your SA or a VC to your OA, SA and MA. 

A MS Top Up to your SA requires more serious consideration because you won't be able to use the money for housing unlike money in the OA. 

However, it would be more rewarding with much higher interest rate of 4% to 5% if your objective is to save early for retirement. 





The magic of compounding is amazing, given more time.

However, if you are not sure and it is hard to be sure when you are only 20, it is best not to do a MS Top Up yet. 

Doing VC to all three accounts will give you more flexibility and enjoy 2.5% to 5% in interest rates at the same time. 

A percentage of the money in the OA could be used for approved investments too while money in the MA could be drawn upon in case of hospitalisation (and MA is also used to pay for our H&S insurance plan).

When you start life as a working adult a couple of years later, you might want to consider doing an OA to SA transfer. 

This will not be an out of pocket exercise. 

It is money in your CPF OA that is being moved. 





You might choose to do this for the first 3 or 4 years. 

It will give your SA a boost and the magic of compounding will do the rest for the next 30 years. 

Of course, you might have to push back your plan to settle down by 3 or 4 years, in such a case.

Think carefully your own circumstances and what you want in future. 






The CPF is a useful tool in planning for a more comfortable and secure retirement but there are competing uses for our financial resources. 

I am only sharing what has worked for me in my blog. :)

Best wishes,
AK

Note:
VC = Voluntary Contributions
MS Top Up = Minimum Sum Top Up






Related posts:
1. A lot of money in the CPF-SA...
2. How did AK amass so much money in CPF-OA?
3. Beef up to attain financial freedom sooner.