Wednesday, 6 October 2010

The benefits of investing in exchange-traded funds (ETFs)

What are ETFs and why is it beneficial to buy them?

Personal Investing - By Ooi Kok Hwa

LATELY, the number of ETFs that get listed on Bursa Malaysia has been increasing.

At present, we have a total of five ETFs listed in Malaysia. Unfortunately, we have noticed that not many investors are aware of these instruments and there is also a lack of understanding on the true value of these ETFs.

ETF stands for exchange-traded fund. Buying into ETFs is almost similar to buying normal mutual funds. The key differences are that investors can buy or sell ETFs in a stock exchange or go through an authorised participant whereas investors can only buy and sell mutual funds through unit trust companies or other financial institutions.

ETF originated in United States. During 1960s and 1970s, some fund managers in the US discovered that it was quite difficult to beat the stock market index. They discovered that it was better to buy stocks that mirrored the index composition as many fund managers found that they tend to underperform the index.

As a result, the ETF industry has been growing in the US from two ETFs in 1995 to more than 900 ETFs listed in the US now. At present, there are many types of ETFs available in the US, for example ETFs on stocks, bonds, commodities, currencies and countries. For stocks, ETFs can be further divided into different types of market capitalisation (big cap vs small cap), equity styles (growth investing vs value investing) as well as different types of sector funds (like ETF on stocks in technology, health care or financial institution sectors).

One of the key advantages of buying into ETFs is that it is cheaper to buy ETFs as compared to normal mutual funds. Investors need to pay about a 5.5% sale charge (also known as front-end load) for normal mutual funds whereas they only need to pay a normal brokearge fee of 0.7% (inclusive of all other charges) for ETFs.

Comparing similar type of funds, the annual management fee for ETFs is generally lower than that of mutual funds.

Normally, ETF will charge about 0.65% per annum (0.6% for the annual management fee and 0.05% for the index license fee).

However, normal mutual funds will charge about 1.5% annual management fee. Assuming an investor intends to buy an index fund and intends to hold the fund for a one-year period, he or she will incur about 1.35% (0.7% - total transaction fee and 0.65% - annual management fee and index license fee).

However, the investor will incur about 7% (5.5% for sale charges and 1.5% for annual management fee) if he buys into the normal mutual funds. Given that ETFs are using the “in-kind” creation and redemption of shares, they eliminate any price discrepancy to net asset value (NAV) due to the supply and demand pressure.

As compared with close-end funds where investors may buy at the premium or discount to its NAV, the price that we pay for ETFs will be closed to its NAV like the normal mutual funds. As an added advantage over mutual funds, ETFs are generally more liquid than normal mutual funds as we can buy and sell them through secondary markets.

Please refer the chart for the mechanism of creating an ETF. The reverse of all of the arrows will be for the redemption of an ETF.

In addition, ETFs provide investors the benefits of portfolio diversification, same as normal mutual funds. Given that they will try to replicate the benchmark indices, their performances will be very close to the indices.

In Malaysia, sometimes we notice that some mutual funds may underperform their benchmark indices.
In short, we believe that there will be more ETFs getting listed on the stock market.
It will be to investors’ benefit to understandhow they can add ETFs onto their investment portfolios as a cost effective investment alternative.

  • Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting 

  • Investing Advice: 5 Benefits of ETFs

    Understanding the strengths and weaknesses of your investment options is fundamental to successful investing. Advice may be limited to how it fits into your particular investment strategy, but ETFs offer an opportunity to diversify without starting out with a great deal of money. Here are the five strengths of investing in ETFs.
    When people ask for investing advice, ETFs usually come up pretty quickly, because they are so heavily marketed and trumped by the industry. Exchange-traded funds, or ETFs, are an easy way to diversify a small investment, but to get the most out of your investment, it is important to understand how they operate.

    ETFs are like mutual funds, in that they are a collection of investments, but they are traded on an exchange, such as the NYSE, instead of purchased directly from the issuing company. They also differ in their redemption structure and tax efficiency from traditional mutual funds.

    Here are five benefits of ETFs over mutual funds:

    1. Tax Efficiency: Upon redemption, mutual funds must sell its underlying securities, and the capital gains are then distributed to the owners of the funds. Since ETFs trade on an exchange and investors are selling to other investors, no underlying securities are sold, and no capital gains are distributed. If the makeup of the ETF changes it will, occasionally have to distribute gains, but it should be less frequent than with traditional mutual funds.

    2. Lower Fees: ETFs are no-load funds, and you won't be slapped with a redemption fee when it's time to liquidate your position. Further, ETFs typically have lower annual fees than traditional Mutual Funds, making them an attractive alternative. (NOTE: In rare cases where a very small amount is being traded, broker's fees may be a higher percentage of the investment than a mutual fund's expenses would be, but in most of these cases the invested amount would not meet the minimum investment required by most mutual funds).

    3. Liquidity: The exchange-traded structure of ETFs generally allow for liquidation of a position faster than a mutual fund, which must be liquidated at end of day. Further, the ability to set a limit order allows flexible trading that no investor could get from a mutual fund. Not all ETFs have the same liquidity, however, and it is important to review trading volumes and the ETF prospectus to determine whether you are comfortable with the frequency of trades.

    4. Intraday Pricing: Because ETFs are traded on active stock exchanges, purchases and sales happen at market prices, rather than end-of-day Net Asset Value, which mutual funds use. As a result, one may purchase ETFs at a premium or a discount to the value of the underlying assets, and arbitrage is frequent.

    5. No Minimum Investment: When starting investing, diversification can be cost prohibitive if you're using traditional mutual funds, which frequently have a minimum investment of $2500 or more. Because ETFs have no minimum investment (other than the market price of one share), they are a good vehicle for diversified investing.

    Of course, many of these benefits could be liabilities if not used properly. For instance, the intraday pricing feature of ETFs could lead an investor to buy an ETF at a premium or sell it at a discount to the value of the underlying securities. Also, brokerage fees may have a greater impact on some investors than traditional mutual funds' management fees and loads would have.

    Used wisely, ETFs can be a good vehicle for widely diversifying a small or initial investment, but it is always best to seek professional investing advice.

    In the future I will cover the five negatives of investing in ETFs.

    By Pat Regan

    An exchange-traded fund (ETF), a member of exchange-traded product-family (ETP), is an investment fund traded on stock exchanges, much like stocks.[1] An ETF holds assets such as stocks, commodities, or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features.[2][3]

    Only so-called authorized participants (typically, large institutional investors) actually buy or sell shares of an ETF directly from/to the fund manager, and then only in creation units, large blocks of tens of thousands of ETF shares, which are usually exchanged in-kind with baskets of the underlying securities. Authorized participants may wish to invest in the ETF shares long-term, but usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates to the net asset value of the underlying assets.[4] Other investors, such as individuals using a retail broker, trade ETF shares on this secondary market.

    An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. Closed-end funds are not considered to be "ETFs", even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. In 1993, the first country specific ETFs were a collaboration between MSCI, BGI and a small independent third party Distribution firm called Funds Distributor, Inc. The product eventually evolved into the iShares brand widely known around the globe. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively managed ETFs.[4]