- While passive investing is a good option for beginners, new investors should look closer at the details behind ETFs
- Certain ETFs can introduce concentration risks, or have leverage embedded
- Generalisations about ETFs, especially when compared to unit trusts, may therefore not paint a complete picture of two investing options
Investing in an exchange-traded fund (ETF) is often recommended as a good option for investors who are just starting on their investment journey. After all, it supposedly ticks all the right boxes of what a fuss-free, long-term investment should entail. You get diversification, low-cost, and professional management all combined in a simple to access product.
Still, with the growth of the ETF market accelerating, it pays to look carefully at what you’re buying into.
What is an exchange-traded fund (ETF)?
An exchange-traded fund is typically a fund that is invested in a pool of investment products, and can be traded on a stock exchange. Popular buy-and-hold ETF options are generally index-tracking funds that directly own the underlying stocks of the index. These popular funds include the SPDR Straits Times Index (SGX: ES3) or the Vanguard FTSE All-World UCITS ETF Fund (LSE: VWRA).
While these vanilla ETF options are indeed more suitable for new investors, there are more complex ETFs available that are not.
Riskier ETFs to watch out for
As the criteria for a fund to be an ETF is very loose, it is up to investors to plough through the ETF prospectus and fact sheet to understand the risk involved. Here are some examples of how ETFs can be riskier than expected.
Concentration risk in specific sectors
While an ETF can provide more diversification than picking single stocks, the diversification benefits are only limited to the fund’s investments. A gold ETF, such as the SGX-listed GLD US$, will only give you exposure to gold prices. If you were to invest in a China technology ETF, such as the popular KraneShares CSI China Internet ETF (NYESEACRA: KWEB), you are still heavily exposed to the risk of China technology stocks.
Since February 2021, KWEB has been massively sold down by about 70% due to concerns around delisting of China technology companies listed in the US, along with Chinese government clampdowns on tech companies. The diversification might have prevented you from picking a poorer performing China technology stock, but it would not have saved you against an industry crisis.
Niche, high-risk investment strategy
ETFs are not just meant for long-term investors, they can also be used by expert investors to express niche investment strategies and gain exposure to different asset classes.
For example, at the peak of COVID-19, work-from-home ETFs (NYSEACRA: WFH) and (NYSEACRA: IWFH) allowed investors to ride on potential outperformance in stocks that will benefit from the shift to remote working.
A bitcoin ETF (NYSEACRA: BITO), which was listed in October 2021, also allows investors to get bitcoin returns.
These ETFs are often listed at the peak of retail investor hype, and are often not based on sound long-term investment fundamentals. It is thus important for investors to exercise caution when choosing between ETFs.
Higher risk through leveraged ETFs
Not all ETFs are directly invested into the underlying stocks. Many ETFs rely on complex financial instruments — that is, derivatives – to give synthetic exposure to certain stocks or indices.
For example, investors of leveraged ETFs get 2 or 3 times the daily gains or losses in a single stock or index. The assumption is that investing in a relatively safer index or blue chip companies allows for the use of leverage for higher returns. However, leverage multiplies losses and gains equally (also known as volatility decay). This effect, combined with higher fund management fees lead to poorer risk-return ratio.
Cost of liquidity and bid-ask spread in ETFs
Unlike typical stocks or bonds, the true value of a share of an ETF can often be determined by calculating the Net Asset Value (NAV) of the underlying listed investments, divided by the total number of shares outstanding.
However, the price that we invest in ETFs are subject to the supply and demand of the ETF in the stock exchange, rather than having it determined based on the NAV. When the markets are stable, ETF prices and NAV are typically close. However, during periods of volatility and uncertainty, there would be greater mispricing of ETFs and you might be purchasing ETFs at a premium over its actual value, or selling it as a discount. This ETF liquidity risk adds up to your total cost of investing.
While ETFs have authorised participants to ensure the ETF and NAV pricing difference is kept minimal, mispricing can still occur within intraday trades.
Unit trusts can be better than ETFs for Singapore investors
Generalisations about ETFs, especially when compared to unit trusts, may not paint a complete picture of the investing options available to those who are just starting out.
For one thing, in general, unit trusts distributed in Singapore already take tax and foreign exchange (FX) for Singaporeans into account, which removes the FX exposure.
There are a handful of unit trusts such as the Infinity US 500 tracking indices passively. There are also systematic passive funds such as Dimensional funds that are managed cost-efficiently, with cost structures equivalent to low-cost ETFs.
Finally, unit trust investing can be as cost-competitive as investing in ETFs when investing through a platform like Endowus, where you pay 0% sales or redemption charge.
Unit trusts or ETFs? Assess investments on substance, not form
Ultimately, ETFs are an investment vehicle that allows easy investment access; it is not innately a superior or inferior way to invest. It is more important to look into the underlying holdings of the funds, as well as the investment mandate of the fund manager before investing in a unit trust or an ETF. If you are looking for an advised solution that has done all that due diligence for you, then using a managed portfolio might be the better option for you.
Get started on investing in low-cost unit trusts here.
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