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Top Reasons To Own Exchange Traded Funds
Featured, Perspective | 09 September 2014
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By: Peter Ng
Articles (81) Profile

Have you ever stepped into a supermarket and not knowing what to buy, despite having prepared a shopping list of items? For some, this would probably sound all too familiar since there are plenty of the same items to choose from the shelves in a supermarket.

The same applies in the financial markets. Even when an investor carefully filters for suitable investments to include in his or her portfolio, it is often inevitable for him or her to end up with a dozen of similar options to pick from.

Although all these would not have been a consideration if one could own everything, unfortunately for most of us who have a finite pool of investment funds, we could only pick a handful from the sea of investment options.

Diversification

However, the caveat of hand picking investments will expose an investor to concentration risk. That is, all is well if his or her investments pan out well. On the other hand, should it turn south, losses incurred by an investor will be heavy. Hence, the solution is diversification.

Only by not putting all our eggs in one basket, would an investor be less susceptible to concentration risk.

Despite knowing the importance of diversification, many investors would not be able diversify their investment portfolios given a smaller pool of funds. This is when exchange traded funds (ETF), a financial instrument listed on the stock exchange that typically tracks a stock index, present their benefits of diversification.

Exchange Traded Funds

An ETF tracking the Straits Times Index (STI) would be able to provide an investor with exposure to the 30 largest companies in Singapore, in terms of market capitalisation.

Furthermore, since the 30 largest companies represent more than 80 percent of the total market capitalisation of all companies listed on the Singapore Exchange, as such an investment in the STI is almost equivalent to gaining exposure to all companies listed on the exchange.

Compared to buying a minimum of 1,000 shares of all thirty companies which amount to a sum of no lesser than a tenth of a million dollars, investing in a STI ETF, taking for example SPDR® STI ETF, requires an investment outlay of $3370 (based on the closing price of $3.37 and minimum transaction volume of 100 shares).

Let us not forget the associated charges involved to place orders for all thirty companies. In addition, savvy investors would probably spread their purchases of their investments a few times in order to lock into the lowest price which further pile up the costs incurred.

ETF Versus Managed Funds

Getting to the juicy part, the net asset value of SPDR® STI ETF has gained 140.4 percent in the ten years ending December 2013 with dividends re-invested, translating to a 9.2 percent annual gain.

Furthermore, the performance of the etf has returned 6 percent including the distribution of dividends between the closing price of 2 January 2014 and 8 September 2014.

Although the performance of 16 unit trust funds which returned an average of 7.1 percent year-to-date could seem higher on hindsight, however these returns do not include fees and charges associated with these funds.

A unit trust’s expenses are approximately 0.6 – 2.15 percent per annum excluding miscellaneous fees, while an etf take for example, SPDR® STI ETF, yields an all-in expense ratio of 0.1 percent. The net effect is a less than five percent return on managed funds while a 5.9 percent return for SPDR® STI ETF.

Snapshot Of Unit Trust's Returns Extracted from Fund Supermart

At this point, it becomes clear why Warren Buffett has famously recommended investors who do not spend six to eight hours daily analysing companies, to put 90 percent of their funds into an index fund invested over a long period of time.

Subsequently, the remaining 10 percent should be held in cash, in preparation to deploy these funds should there be a large decline in the market.

While the returns of etfs may not be astounding, however, granted the consistency as seen from their past performance, these instruments have a strong case to be included in a defensive investor’s portfolio.

Backed by a strong interest in investments, Peter's research spans across a range of industries, with his focus placed on companies listed on the SGX.

Please click here for more information about this author.


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