Why ETF Might Be For You?

Buy low, sell high

This is a common virtue in the realm of investment. The problem is, we often aim to buy low and sell high. The act of timing the market is a tough row to hoe especially when it is driven by a mixed bag of rational and irrational expectations. An attempt to do so gives rise to emotional investing, where one will cave in to herd activity, thereby losing control over their investment portfolio. It impairs sound judgement in buy and sell decisions.

How can emotional investing be prevented? A combat plan against it includes discernment towards market noises, maintain a long-term perspective on investment, and have a diversified investment portfolio. On top of that, it is important to perform due diligence; know your risk tolerance, know the nature of the company you have invested in, and believe in its business model. This knowledge will keep investors grounded during times of volatility.

Whether you have little time to do your due diligence or have just begun investing, one of the better ways to start your investment journey is to invest in a managed diversified investment portfolio. While Mutual Funds quickly comes to mind, another well-known investment product is Exchange Traded Funds (ETFs).

An ETF is a passively managed portfolio of securities traded on major exchanges. The portfolio of securities aims to emulate the performance of a certain index, sector, country, or region across a range of both traditional (stocks and bonds) and alternative asset classes (currencies and commodities). ETFs allow an investor to quickly own a diversified investment portfolio at minimal cost.

Most of the ETFs available in the world are index-based funds. Some have metamorphosized in the way they track the performance of the underlying benchmark. One such ETF is the inverse ETF which generate returns from a decline in the underlying benchmark. Another example would be the Leveraged ETF, which aims to beat the returns of the underlying asset or index it tracks by employing financial derivatives. Both types of ETFs are available on the Malaysian market.

To date, there are 19 ETFs listed on the Malaysian bourse offered for various asset classes and sectors. They consist of 1 commodity ETF, 11 equity ETF, 1 fixed income ETF, and 6 Leveraged and Inverse ETF. While ETFs are experiencing fast growth in volume in countries like the U.S and Hong Kong, the total Asset Under Management (AUM) for these 19 ETFs pale in comparison to that of Mutual Funds, which is still the preferred Investment product amongst investors in Malaysia.

An ETF shares rather similar characteristics with a Mutual Fund in that they are both diversified portfolios. However, there are some stark differences that make ETF an equally compelling investment product.

Flexibility 

An investor buys and sells Mutual Funds based on its Net Asset Value (NAV); a price determined only at the end of each day. This means that upon the decision to buy and sell a mutual fund, an investor will only know the price at which it is transacted at the end of the day. On the other hand, for ETFs, an investor can buy and sell based on its market price, which is the price reflected on the exchange, similar to a stock. The fluidity means it is more convenient for an ETF to be bought and sold. Furthermore, in Malaysia at least, Mutual Funds have an earlier transaction cut-off time as compared to ETF, which follows the bourse’s opening hours.

Transparency

A mutual fund’s holdings, typically the top 10, are displayed on its monthly fund factsheet. For an ETF, the composition is displayed on Bursa’s website and gets updated daily. In terms of performance measurement against a benchmark, ETFs are purposed to track their chosen benchmark with low tracking error. As for some Mutual Funds, peer fund review is warranted in the absence of a benchmark that best represents its investment strategy.

Cost Structure 

As mutual funds are actively managed and must be purchased from financial institutions or other private platforms, management fees and distribution fees are naturally higher than that of an ETF. For management fees, a mutual fund can be charged any rate between 1% to 2%, while ETFs charges fall between 0.2% to 0.8%, both for management fees per year of the fund’s NAV. For other costs, an investor can be charged between 1% to 5.5% in distribution fees for every purchase of mutual funds. While ETFs, like stocks, gets charged the usual brokerage and stamp duty fees.

Passive strategy

Perhaps there lies an inherent scepticism that a passively managed fund equates to low returns. A quick analysis of the performance of our local ETFs suggests otherwise. To quote a few examples, the 1-year accumulative return for Trade Plus Shariah Gold Tracker as at 18 March 2021 was 14% versus its benchmark of 15%. The same period returns for Trade Plus NYSE FANG+ Daily Leveraged Tracker was at 365.46% versus its underlying index of 159.27% and a benchmark of 461.3%. While it does not aim to beat the benchmark like Mutual Funds do, these performances are hardly low. On top of that, a passive investment strategy means that the skills of a fund manager will not affect the performance of the fund.

Investing in an ETF makes sense for both astute and new investors. A plain vanilla ETF can help to reduce an investment portfolio’s beta. For example, if an investment portfolio is heavy on cyclical stocks, an ETF tracking S&P 500 can help to lower the overall beta value by quickly giving the investment portfolio exposure to defensive stocks. If you have a higher risk tolerance, thematic ETFs or leveraged ETFs can potentially help to generate more returns, while preserving the level of diversification. Due to an ETF’s low expense ratio, an allocation into ETFs helps to minimize transaction costs. This is particularly helpful for a tactical portfolio, where frequent portfolio rebalancing is required. As for new investors, ETFs help to achieve a diversified investment portfolio without needing a lot of research and principal.

As mentioned earlier, one way to take emotions out of the equation is to have a longer time horizon for investments. This is because the market is a better reflection of its fundamentals in the long-term rather than the short-term. History shows that market performance improves over a longer period. When investing in ETFs in the long-term, one will reap the benefits of the compounding effect. Not only because it is able to track the benchmark, the low cost of investing in ETFs means that more of an investor’s money is pumped into the actual investment itself.

In conclusion, ETFs complement other investment products such as mutual funds, and are also good as a standalone in a new portfolio for quick and affordable diversification. If you are looking to inject some breadth of diversification in one form or another in your portfolio or are too caught up to monitor your investment portfolio all the time, ETFs might just be right for you.