The basics of ETFs in Singapore
What are ETFs?
Exchange-Traded Funds, also known as ETFs in Singapore, have become increasingly popular in the private wealth industry. An exchange-traded fund is a managed basket that holds securities such as stocks or bonds which tracks an index like the Straits Times Index (STI), S&P 500 or FTSE 100. Like mutual funds, investors can purchase units through either brokers or banks, and these units typically trade on the stock exchanges throughout various trading hours.
ETFs allow you to participate in market movements without purchasing each equity. Unlike unit trusts, an investor does not buy into the net asset value (NAV) of an ETF at end-of-day prices; instead, one purchases or sells ETF units at prevailing market prices. It makes them ideal for investors who seek to capitalise on short-term opportunities without the concern of specific timing in the market.
Benefits of investing in ETFs
As compared to mutual funds, they tend to be more tax-efficient as they distribute dividends and capital gains less frequently than mutual funds.
ETFs typically carry lower expense ratios than actively managed mutual funds due to their passive investment style; this will generally translate into more significant long term returns. It is due to indexing which reduces turnover costs, passed onto mutual fund holders through higher fees.
They may also come with lower minimum initial purchase amounts (e.g., S$5,000).
These are an excellent alternative to individual stocks, allowing investors to diversify their portfolios at a lower cost.
Drawbacks of investing in ETFs
ETFs do not guarantee the same returns as the index they track, and most ETFs underperform that they aim to mimic. It can be due to fees, operating costs and tracking errors.
There is also no guarantee that an investor will receive any dividends or interest earned by the securities making up the relevant index. Thus unlike mutual funds where income distribution is guaranteed, investors purchasing shares in an ETF need to wait for securities within the basket to pay out before receiving any dividend payments themselves.
Additionally, unlike mutual fund units, investors cannot redeem their units with ETF distributors on demand. ETF distribution is driven mainly by market forces. Investors can only sell their units in the secondary market at prevailing prices when ready to liquidate their positions. It makes liquidity a concern for ETF holders as disconnects between the bid and asks prices may result from low trading volumes in the secondary market.
Before you invest in ETFs
Investors considering investing in ETFs should account for brokerage fees, which will typically have a direct impact on your final returns. Brokerage fees can swallow up anywhere from 0.20% – 1% of your investment each time you buy or sell ETF units, which can add up if you’re frequently trading. For brokers that are affordable and that you can trust, you can check here for more info.
While ETFs do not come with the same capital gains tax as actively managed mutual funds, investors may still incur dividend distribution tax on their returns.
ETFs are traded on the stock exchange, and thus, prices will fluctuate during daily trading hours at market open and close. These price movements of individual securities within the ETF basket will be passed onto investors.
Thus unlike buying into a unit trust where there is no movement in NAV throughout its lifetime, an investor purchasing shares in an ETF needs to factor in the impact of capital gains or loss over time. For example, you need to account for bid-offer spreads when selling your ETF units on the secondary market (and paying brokerage fees).
You will also need to factor in currency conversion costs when investing overseas. Some ETFs may even be subject to currency risk where foreign exchange fluctuations drive price movements.