Exchanged Traded Funds, more commonly known as ETFs, are a type of investment fund that is traded on the stock exchange.
If you have been following DollarsAndSense.sg for some time, you would know that we are big fans of ETFs. ETFs allow investors the ability to invest into economy or sectors, without needing to buy individual stocks to create their own portfolio.
While ETFs are currently the darlings of the investment community, and are poised to disrupt the asset management industry, they are not without their own limitations.
Here are 3 dangerous myths about ETFs that retail investors need to know about.
# 1 ETF = Diversification
Most ETFs are built to track an index. Since indexes are deliberately constructed to be good proxy for the market, it’s sometimes assumed that ETFs themselves are naturally diversified.
ETFs are investment funds filled with different types of investments. These include stocks, bonds, or whatever the ETF is supposed to have. Whether this investment fund is “well-diversified” really depends on a couple of key factors.
Firstly, what exactly is the ETF constructed to track and purchase?
If you were to purchase the Phillips SGX Dividend Leader REITS ETF, then you would be buying the best dividend paying REITS around Asia.
A closer look at the ETF would reveal that 59% of the REITS in this ETF are based in Australia, with 30% from Singapore, and the remaining 11% from Hong Kong.
This means that an investor who buys the ETF is basically purchasing REITS from Australia and Singapore. Is this considered a well-diversified ETF? Well, it really depends on what your investment objectives are.
What Are Your investment Objectives?
Are you looking to obtain a portfolio that gives you stable dividend income, regardless of the economic situation? Are you looking to invest in high quality companies, regardless of whether or not they give dividends? Or are you looking to gain geographical diversification and hedge yourself against a possible recession in Singapore?
You see, whether or not you are truly diversified depends very much on your own investment objectives, rather than the ETFs you choose to invest in.
For example, the STI ETF is great if you are looking to get diversification across the biggest listed companies in Singapore. However, if you were looking to gain diversification to protect yourself against a local recession, then it would not deliver the type of diversification you seek. In this instance, other ETFs such as the ABF Singapore Bond Index Fund may be the better option instead.
# 2 I Only Need To Invest In ETF
One of the biggest appeal factors that ETFs offer investors is the ability to get a portfolio of stocks just by buying a single unit. This means less work for individual investors, as we no longer need to painstakingly buy each stock just to try replicate the market index.
However, it does not mean that just buying ETF only would be sufficient for all our investment needs.
A well-constructed portfolio should ideally include asset classes such as stocks, bonds, properties and cash. Buying an ETF, even one such as the STI ETF, only fills up the stock portion of our portfolio at best.
Avoid putting all your investable money into stock ETFs. An ETF is one good investment instrument that you can use; it does not translate into just dumping all your money into it.
Read Also: 5 Types Of ETFs You Never Knew Existed
# 3 All ETFs Are Constructed The Same Way
ETFs are constructed via two main methods. Physical replication and synthetic replication. It’s important to differentiate between the two. The explanation is a little technical so bear with us.
Physical replication is what you imagined an ETF should be doing. Based on the index that it is tracking, an ETF fund manager would go out to the market and buy the exact same stocks that are in the index. They track the index by buying, in exact portion, the stocks in it.
A synthetic replication ETF aims to deliver the same returns from the index that it is tracking without buying and owning the stocks within the index. Instead, what it does is to enter into a swap agreement with another counterparty, which would promise to deliver the returns of the index that it is tracking to the ETF and its investors.
In a brief summary, a physical replication ETF tracks the index and delivers returns by actually buying and owning the stocks within the index. Synthetic ETFs deliver the same returns without actually buying and owning the stocks within the index.
It’s important to know whether or not the ETF you buy it’s a physical replication or a synthetic replication. If it were a synthetic replication, then you would need to look at who the counterparties are for the ETFs, and whether or not they are credit worthy.
Want to learn more about finance in a fun and interactive way? Why not join us in a round of Wongamania. Along with the team behind Wongamania, DollarsAndSense is organising the Wongamania Social Series as we aim to bring people together to pick up personal finance knowledge through the economy board game, Wongamania. Stand a chance to also win a FitBlaze Fitness watch at the event.
Event: Wongamania, The Social Series
Date: 25 October, 6.30pm – 9.30pm
Venue: The Digital Garage, 38 Armenian Street Singapore 179942
Cost: $8 per person