We shared about Active vs Passive investing where we highlighted how ETFs make great passive investment tools. But what do ETFs really entail and what should you look out for in an ETF?
What are Exchange Traded Funds (ETFs)?
An Exchange Traded Fund is a basket of assets such as stocks, commodities, or bonds that trade on an exchange like the Singapore Exchange or Hong Kong Exchange. ETFs often track an underlying index that could be based on an Index or industry.
ETFs can be a cost-effective way of investing your money passively. They share characteristics similar to mutual funds and stocks. Like a mutual fund, an ETF provides easy access to a portfolio of stocks or bonds and offers diversification through a single security. Similar to a stock, an ETF can be bought or sold throughout the course of a day as long as the stock exchange is open. ETFs are commonly used as passive investments and they aim to replicate the performance of a specified index, such as the S&P 500. An example of an ETF that tracks the S&P 500 is iShares Core S&P 500 ETF.
What should you look out for when selecting ETFs?
It’s important to consider the cost of trading and holding an investment. Since you’re purchasing an ETF as a passive instrument, you wouldn’t want to pay excessive fees for an ETF as you aren’t engaging a fund manager to make investment decisions on your behalf.
Although ETFs are known for their cost efficiency, investors should take note of the Total Expense Ratio (the cost of holding an ETF) before buying in. The Total Expense Ratio accounts for all operational and management costs of the ETF and it includes costs such as management, legal and auditing fees. For example, an ETF that has an expense ratio of 0.50% would deduct half of one percent from the fund’s assets on an annual basis. In dollar terms, an expense ratio of 0.50% translates to an expense of $5 for every $1,000 invested and the investor will receive the total return of the ETF, minus these expenses. You want to look out for an Expense Ratio of less than 1%.
Assets Under Management (AUM)
The volume of Assets Under Management directly impacts an ETF bid or ask spread. This refers to the difference between the highest price at which an investor is willing to buy a share of the ETF (bid price) and the lowest price that someone else is willing to sell it (ask price).
The bid or ask spread is a somewhat hidden cost that you don’t feel the direct impact of. Imagine that the bid and ask prices of a stock are $5 and $10 respectively. If you bought the stock at $10 (ask price) and immediately changed your mind and decided to sell the stock at $5 (bid price), you would have lost $5 ($10 – $5), which is the bid or ask spread.
This spread compensates the broker (which matches buyers and sellers) for taking on the risk of being a market maker for the stock. If a broker buys a stock from you at $5, he runs the risk of not being able to find other willing buyers to sell the stock at $5 or more. He might instead lower the price at which he buys from you to $4 instead and widen the bid or ask spread. ETFs that have a smaller AUM, tend to trade in illiquid markets where there are not many buyers and sellers transacting. The bid or ask spread for these ETFs tend to be wider to protect the brokers and the cost of trading tends to be higher for investors.
Another advantage that size gets you is the reduced risk of an ETF closing. Some ETFs are closed because they are not big enough to remain commercially viable. This can be frustrating for existing investors, who may have their capital gains realised, which means they will have to pay taxes. It is also likely that you will have to redeploy these new funds into other investments which will result in incurring another set of trading costs.
Withholding of taxes mainly occurs in the country where the underlying equity or fixed income investments of your ETFs are domiciled (country where ETF is listed). The tax rate can be avoided if there is a treaty between the country of the investor and the country that the ETF is from. Consider an example where a Singaporean investor buys a US-domiciled ETF investing in US equities. As Singapore does not have a tax treaty with the US, you are required to pay a total of 30% withholding taxes:
0% Investment Level + 30% ETF (Fund) Level = 30% Withholding Tax
Alternatively, if you are investing in an Irish-domiciled ETF investing in US equities, as Ireland has a tax treaty with the US, you are required to pay a total of 15% withholding taxes:
15% Investment Level + 0% ETF (Fund Level) = 15% Withholding Tax
By buying into the Irish-domiciled ETF which gives you the same US equity exposure, you save yourself 15% withholding tax.
The goal of an ETF index fund is to track a specific market index. The difference between the returns of the ETF and the market index is known as the ETF’s tracking error. More often than not, investors may be persuaded to purchase the ETF with the lowest fees, however this may not always be advantageous if the fund does not track its market index as well as expected. The ETF’s R-squared and beta are some key metrics to tell how well the ETF tracks the market index. The closer the R-squared or beta is to 1, the closer the ETF’s performance will match those of the market index.
As most popular ETFs are listed on a stock exchange outside of Singapore and are denominated in a non-SGD currency, Singaporean investors need to be aware that any potential foreign exchange rate fluctuations might affect the total return of your investment.
For example, if you bought an ETF that invests in the US stock market, and the US stock market prices rose by 5% while the dollar lost 5% against the Singapore dollar, then you would register a 0% total return.
An ETF can be an effective investment if you’re looking for a passive instrument that provides diversification. Take note of the aspects mentioned above and you’ll be better able to evaluate the various ETFs available.