Introduction

You’ve probably heard of Exchange-Traded Funds (ETFs) from the investment community. It’s usually the same description – they are low cost and efficient diversification financial products.

But the ETF world is much more complicated than that. It is filled with many different types of ETFs and technical jargons that may confuse or even intimidate the everyday investors.

Fret not, in this article, we will take you through the basics of ETFs, the terminologies in an ETF factsheet and the things to look out for before investing in ETFs.

This article will guide you to learn how to utilise ETFs for your investment journey.

What is an ETF?

ETFs are open-ended investment funds with a primary objective of tracking its benchmark index.

It is a marketable security that trades like a common stock on stock exchanges around the world. As an investment fund, ETF holds a diversified portfolio of securities to achieve its index replication objective.

In summary, ETFs are investment funds listed on exchanges and trade on exchanges like a stock.

Types of ETFs

Market Capitalisation Weighted ETFs

These ETFs track their respective capitalisation-weighted indexes. The index components are selected and weighted according to the total market value of their outstanding share units (share price * total number of outstanding share units).

For example, the Straits Times Index (STI) comprises the top 30 companies listed on the Singapore Exchange (SGX). If the market capitalisation of one of the STI’s constituents falls below the top 30 ranking, another better performing company will replace it on the index.

Examples of Market Capitalisation Weighted ETFs

Smart Beta ETFs

Unlike traditional Market Capitalisation Weighted ETFs, Smart Beta ETFs use an alternative rules-based index construction strategy.

By adopting a rule-based approach to selecting its constituents, Smart Beta ETF aims to quantify its index criteria and eliminate any irrational behavioural factors from portfolio management.

ETF issuers often launch Smart Beta ETFs to target any gap in the saturated ETF market space and serve unmet investors’ needs.

Examples of Smart Beta ETFs include Lion-Phillip S-REITs ETF (SGX: CLR) and Phillip Sing Income ETF (SGX: OVQ).

Actively Managed ETFs

Actively managed ETFs belong to a class of ETF that does not adhere to the passive index replication strategy. They invest in a portfolio of securities that are subjectively chosen by their fund managers.

The fund managers have the liberty to adjust the securities and portfolio allocation within the fund while not being limited to the fixed rule of tracking an index.

Actively managed ETFs have the potential to outperform their benchmark indexes through the investment decisions made by their fund managers. However, the higher transaction cost of managing the funds may result in higher expense ratios when compared with traditional index-tracking ETFs.

Nikko Asset Management launched the first actively managed ETF in Asia on HKEx in June 2020. The NikkoAM Active E-Games ETF (HKEx: 9091) has the flexibility to rebalance its underlying assets daily to adapt to the ever-changing landscape of the E-Games industry.

Leveraged and Inverse ETFs

There are special classes of ETFs available in the market that allow investors to leverage or short their investments directly without the need to deposit a margin or borrow stocks respectively.

The availability of leveraged and inverse ETFs allows investors to hedge their portfolios or engage in tactical trading to gain exposure to specific market trends.

Leveraged and inverse ETFs are highly volatile trading instruments meant for short-term trading purposes only.

ETF Replication Method

The following are ways for an ETF to achieve its index-tracking objective:

1) Full Physical Replication

Full Physical Replication ETFs invest all of its assets in the constituents of the benchmark index, in proportion to the weight of the constituents in the index.

2) Sampling/Partial Replication

Instead of investing all of its assets in the constituents of the benchmark index, an ETF may choose to invest in only some of the constituents in the benchmark index. There are various reasons for adopting the sampling replication technique:

• To improve the performance of the ETFs by omitting underperforming securities
• It is impossible or not cost-effective to purchase all the securities in the benchmark index

3) Synthetic Replication

Synthetic ETFs purchase futures, options and other derivatives instruments in exchange for the benchmark index performance. There are various reasons for adopting this synthetic replication approach:

• To gain access to obscure or less liquid markets
• To reduce tracking error
• To replicate unique benchmark index
• To overcome the problem of incurring high transaction costs (e.g. Commodity ETFs do not have to incur storage, insurance and logistics costs)

ETF Factsheet Terminologies

An ETF factsheet contains several technical terms and definitions. Moreover, different ETF issuers present their ETFs’ factsheet data differently, which may further confuse investors.

Nevertheless, once an investor learns the different terminologies used in an ETF factsheet, he/she will be able to make informed decisions about his/her choices of ETFs in the future.

Below are the common terminologies used in an ETF factsheet:

Benefits of ETFs

To date, ETFs are getting immensely popular among investors and the number of ETFs available in stock exchanges globally has grown from only one ETF in 1993 to almost 7,000 ETFs by the end of 2019.

So why are ETFs gaining popularity and what are the benefits of investing in ETFs? We shall explain them in detail in this section.

Conclusion

ETFs have quickly grown in popularity because of their cost-effectiveness, transparency and liquidity. Moreover, ETFs offer the additional benefit of instant diversification.

The advent of ETFs allows investors to gain exposure to macro trends in a convenient and efficient manner. Investors need not choose specific individual stocks for their investment strategy. They can simply select the ETFs with the investment objectives that match their desired market theme or strategy.

With thousands of ETFs available in stock exchanges around the world, investors can now tailor-make their own portfolio to gain exposure to worldwide trends and asset classes.

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