Good Times Fund Times?

Cheah Meng Choo explains the mysteries of Exchange Traded Funds in the first of a two-part article

 

 

AN INTRODUCTION TO ETF: A 60 SECOND GUIDE

Puzzled by what an Exchange Traded Fund (“ETF”) is? Heard about so-called index-linked funds but don’t understand how it works? Well, if you are still puzzled or confused with the mechanics of an ETF, you are not alone! Welcome aboard as we invite you to join the club in learning and understanding the concept of ETFs in Malaysia.

 

Although a relatively new concept here in Malaysia, ETFs have been around since the early 1990s. In a nutshell, an ETF is an open-ended investment fund that comprises a portfolio of securities, equities, bonds or other commodities. ETFs are listed and traded on Bursa Malaysia Securities Berhad (“Bursa Malaysia”). More importantly, the main feature which distinguishes ETFs from other collective investment schemes such as that of unit trust funds (“UTF”) or real estate investment trust funds (“REIT”) is that ETFs are designed to track the performance of an index in a particular market or sector. Hence, ETFs are also commonly referred to as index-linked funds. ETFs are just about the simplest kind of funds there can be as all that the fund manager needs to do is to mimic the index which the ETF is tracking by making sure that the ETF has exactly the same proportions of components as the index which it is tracking.

 

The introduction of ETFs adds variety to the type of investments that are available on Bursa Malaysia. The release of the Guidelines on Exchange Traded Funds by the Securities Commission on 21.6.2005 (“ETF Guidelines”) establishes a regulatory framework for the introduction of ETFs and to safeguard the interest of investors. Investing in ETFs allows investors to enjoy diversified exposure to a portfolio of securities in specific markets or sectors without the cost and hassle of buying all the securities individually. Just like trading in specific stocks, the ETF investors may buy and sell this fund through the broker at any time during a trading day.

 

 

THE MECHANICS OF AN ETF

To understand what and how an ETF tracks, it is important to know what an index is. An index is a representative number which allows investors to understand the condition of the subject matter in question. Bursa Malaysia is responsible for computing the indices for each of the main sectors traded. The method in which these indices are computed may vary; some are computed on simple average closing price while others are based on a weighted average price of the component stocks. There are at least 14 different indices calculated electronically by Bursa Malaysia, but the most commonly tracked index by most investment funds is the Kuala Lumpur Composite Index (“KLCI”). So for example, a technology index would indicate the health of the technology market which is determined by the performance of technology companies.

 

As an index-linked fund, the ETF will mimic the performance of an index as close as possible. In order to do this, the ETF must hold the same type of components in the same proportions as the weightings of the index. In that sense, the fund manager may buy a number of stocks proportionate to the amount of stocks of which the index holds to mimic the movement of the index. Quite often, ETFs are exposed to economic, political, social, legal or other risks of a specific sector or market related to the index which the ETF is tracking. These risks inevitably affect the performance of the index. Ideally, the fund manager will try to ensure that the portfolio replicates the index components as closely as possible and that the fund stays as fully invested as possible. In reality, it may be difficult to fully replicate most indices, especially those that are based on a large number of underlying components. The disparity between the performance of the ETF and the performance of the underlying index i.e. the measure of the deviation between the ETF’s total return and the total return of the index is known as ‘tracking error’.

 

 

TRACKING ERRORS: UNDER THE LENS

Tracking errors may arise due to various factors such as failure of the ETF’s tracking strategy, impact of transaction fees and expenses incurred to the fund or even corporate actions relating to the underlying securities of the ETF. A well-run index will generally have a small tracking error. There are a number of factors (which are not intended to be exhaustive) that may contribute to tracking error. Where an ETF does not fully replicate the index, the tracking error may be greater. Factors that contribute to such deviation may be incorrect weighting of stocks in the portfolio, poor portfolio representation of benchmark or poor stock combination.

 

Tracking errors may also be related to changes in the composition of the index. The fund manager has the discretion to change the components of the index to give a better reflection of the market conditions. In most cases, stocks that are considered the current market leaders will be included but this may change from time to time. Using the KLCI as an example, Bursa Malaysia will review the KLCI and decide whether to release or replace any companies as component stocks. For example, if a particular company falls into the least active annual trading volume, it may be removed as a component stock underlying the index. The objective of the KLCI is to reflect the changes in the national economy as well as evolvement of the corporate sector.

 

Expenditure incurred by the ETF such as transaction costs associated with trading in securities also affects the ability of the ETF to replicate the performance of the index. Ideally, the entire fund would be invested in the components of the underlying index. This however is not possible as the fund incurs expenses towards the day to day management of the ETF or transaction fees payable at the time of purchase or sale of securities. These expenses will have to be met out of the fund which means that the fund will invest less than what it has collected.

 

This in turn affects the returns as the fund will receive returns only on the amount which is invested. Hence, the lower the expenditure incurred by the fund, the lower will be the tracking error. Other risk factors such as legal, political, economical and social conditions which could have a material adverse effect on the economy may also affect the performance of the index and in turn affect the trading price of the ETF, its total returns and its ability to meet its objectives. Depending on the performance of the components underlying the ETF, the ETF may either outperform or underperform the index.

 

 

WHY ETF?

The ETF being an index-linked fund offers “market level” performance which is aimed to consistently match the market of a specific index no more and no less whether in advancing or declining markets. Investors are able to replicate gains and losses of the basket of securities which the ETF is designed to track without the expense of buying all the underlying securities.

 

Traded at affordable levels, ETFs require minimum investment from investors but at the same time offers diversified exposure to a wide array of securities. ETFs are highly liquid investments as they are traded on Bursa Malaysia and may have market makers who act as counter-parties in trade execution. Furthermore, trading information of ETFs is easily accessible on a real-time basis. The underlying index and constituent securities of ETF are transparent and price quotations are disseminated during trading hours. More importantly, ETFs are particularly attractive for those who do not have adequate time or resources to closely monitor business and financial developments of individual companies. The returns may not be as high but the risk is certainly lower too.

 

 

WHAT SHOULD INVESTORS LOOK OUT FOR?

Before investing in an ETF, prospective investors should carefully consider all information relating to the fund, such as the investment objectives, tracking strategy and the index which it tracks. Such information is usually available on the ETF’s website and promotional materials. Investors are also advised to seek professional advice from their relevant advisers about their particular circumstances before investing. Investors should also take note of the ETF’s dividend policy as some ETFs may or may not distribute dividends to its investors. They should also be aware that there are certain fees and charges, such as brokerage, clearing fee and stamp duty, which are to be borne by them. Last but not least, investors should also obtain all relevant information about the management company.

 

 

ETF, THE WAY FORWARD?

The first Malaysian ETF known as the Asian Bond Fund (ABF) Malaysia Bond Index Fund (“ABF Fund”) was launched on 18.7.2005. The ABF Fund is listed on Bursa Malaysia and is designed for investors who seek an index-based approach to investing in a portfolio of government and quasi-government debt securities. The ABF Fund closely replicates the returns of the iBoxx® ABF Malaysia Bond Index. The launch of the ABF Fund marks another important milestone in the development of the Malaysian bond market in contributing to the growth of Malaysia’s economy.

 

Quite apart from ETFs, there are several alternative collective investment schemes available to potential investors such as REITs, UTFs and close-end funds. As an ETF is designed to track a designated index, investors will reap profits if that index goes up. The corresponding drawback is that they will incur losses if there is a downturn in the sector being tracked. Although investors are unlikely to make exceptional gains by investing in ETFs, risk in such investments are significantly lower. If steady growth over the long haul with less risk is what one desires, an ETF is an interesting option to consider. In the second part of this article, we will explore the ETF Guidelines to provide the reader with some insight into the legal elements involved in the establishment and management of ETFs.

 

 

CHEAH MENG CHOO ( This e-mail address is being protected from spambots. You need JavaScript enabled to view it )

 

 
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