Passive investing through exchange traded funds (ETFs) have become more popular over the years, especially as active managers find it difficult to beat the market. As the popularity of ETFs continue to boom, they may become a staple in most investors’ portfolio. As investors learn to invest in ETFs, there are three key points to pay attention to.
3 Things to Take Note When Investing in ETFs
Forex (FX) And Liquidity Risks
As ETFs are equity-related investments, there are bound to be risks associated with them. While most investors are familiar with market risk (i.e. ETF is exposed to the price fluctuation of the component stocks that it is tracking), investors often tend to overlook the presence of FX and liquidity risks.
Whenever investors invest in ETFs that are quoted in foreign currencies, they are exposed to FX risk. Based on the ETFs listed on SGX, most of the ETFs are quoted in US dollars. Thus, unless investors buy ETFs quoted in Singapore dollars, they will be exposed to FX risk.
Even for investors investing in ETFs quoted in Singapore dollars, they may still be indirectly exposed to FX risk. For example, HPH Trust is an STI component stock and is thus, part of an STI ETF. However, HPH Trust is quoted in US dollars while the STI ETF is quoted in Singapore dollars.
The other overlooked risk is the liquidity risk of ETFs. Most ETF investors trade only in the secondary market through stock exchanges like SGX. Thus, in order to facilitate trading in the secondary market, market makers have to provide the liquidity, i.e. the bid and offer price. In extreme market conditions, investors might face difficulty selling their ETFs as liquidity dries up.
Synthetic ETFs vs Physical ETFs
The naming of ETFs can often be misleading to investors. Just because an ETF is named STI ETF, it does not necessarily mean that it replicates the component stocks of the STI.
There are two types of ETFs in the market: physical ETFs and synthetic ETFs. The major difference between the two is the components that each ETF holds.
- Physical ETFs track their target indexes by holding all, or at least a representative sample, of the component stocks that make up the index.
- Synthetic ETFs however, relies on derivatives to replicate the performance of the index.
It is important to highlight here that the difference in the make-up of ETFs can affect the performance of the ETF that investors own. The two types of ETFs are just not the same, even if they sound like they are the same.
Note: One way to identify synthetic ETFs is by looking for the ‘X@’ symbol under the SIP column on SGX. An example of a synthetic ETF is DBXT CSI300 US$ (KT4).
Understanding What Makes Up The ETFs You Are Investing In
The lack of understanding of the true components of ETFs can lead to a costly mistake for investors. Buying an ETF without understanding the exposure each ETF has is like buying a box of chocolates without knowing what type of chocolate or how many is inside the box.
There are some investors who are trying to expose their portfolios to different ETFs, thinking that by mixing ETFs, they can achieve ‘diversification‘. For example, emerging markets ETFs like Lyxor ETF MSCI Emerging Markets Index and db x-trackers MSCI Emerging Markets Index UCITS ETF do not have the same composition despite both being emerging markets ETFs.
Without having a good understanding of the true composition of ETFs, investors will find it difficult to achieve the desired diversification effect on one’s portfolio. Investors may even end up being overexposed to certain classes of assets because of the lack of understanding of the ETFs they are buying.