What are ETFs?

An Exchange Traded Fund (ETF) is an open-ended investment fund that is traded and listed on a stock exchange throughout the day. ETFs are simple and effective investment tools that operate similarly to index funds by tracking a particular commodity price or index, such as the S&P 500, and replicating the performance.

ETFs are a great option for those who want to participate in the capital market but don't want or have no idea which securities or stock to pick. As ETF offers a quick, easy, and affordable way to expose to a variety of investments including global stocks and bonds, emerging markets, real estate, commodities and currencies without the need to buy each investment individually. (Martin J. Pring)

In this article, we'll give you a brief overview of ETFs and why ETFs are good investments.

Key takeaways

• ETFs can provide investors with portfolio diversification, lower fees and are easy to understand.
• Some of the disadvantages of ETFs include liquidity issues, risks associated with the underlying assets, and the potential for underperformance compared to individual stock picking.
• ETFs are widely seen as more advantageous than mutual funds because they offer greater flexibility, cost efficiency, and transparency.
• ETFs offer a number of benefits, including diversification, lower risk and time-saving advantages, compared to their underlying assets.

Gain for Investors

1. Capital Growth

Investors will gain money when they sell the ETFs after the value of the underlying securities of the ETFs rise. (Jen-Li Lim)

(Note: Investors will pay at the “ask price” and sell at the “bid price”)

2. Dividends

ETFs do distribute dividends. normally on a half-yearly or yearly basis if the underlying stocks held within the ETF pay dividends (Kevin Voigt & Alana Benson). Investors can always refer to ETF's prospectus on the company's website or Bursa Malaysia to get more information on the ETF that investors are curious about.

The timing of ETF dividend payments varies based on the ETF’s issuers and is on a different schedule from its underlying stocks.

For example, FTSE BURSA MALAYSIA KLCI ETF distributes its dividend on a half-yearly basis. However, its holdings (Public Bank Berhad, Petronas, Digi, Nestle etc) pay dividends at different time periods. Showing that the timing of dividend distribution for ETFs does not depend on the time its underlying pays dividend, but it depends on the ETF itself.

(Note: Similar to stock, there are Ex-Date, Entitlement date, and Payment date for the Income/Dividend distribution of ETFs that will be announced on Bursa Malaysia)

Advantages of ETFs

1. Diversification

ETFs, provide investors with the opportunity to diversify their portfolios. With one single ETF buy order, ETFs hold a basket of securities that may be made up of shares, bonds, futures or commodities, depending on the type of ETF. As a result, ETFs can lower the risk and volatility of investors' portfolios during tough times.

(Note: Kuppuswamy and Villalonga (2015) investigated the effect of diversity during the financial crisis of 2007–2009 and discovered that there is strong evidence that diversification adds value during the financial crisis and indeed helps to protect investors’ portfolios during times of economic turmoil (Ivonne A. Liebenberg))

2. Lower fees

ETFs are more cost-effective to purchase as with a small amount of money, investors can access a wide range of securities at much lower yearly management costs.

Transaction costs can be reduced since buying an ETF gives investors access to a variety of assets rather than having to purchase and sell each security separately, which will incur a number of transaction costs that would be expensive.

3. Simplicity

Since ETFs are listed on the exchange (Bursa Malaysia Main Market), ETFs can be bought and sold quickly and easily at their current market price on Bursa Malaysia. While all information is easily accessible and transparent as all are updated on ETF announcements. Moreover, the transaction can be done through a stockbroker or even a Robo advisor.

Disadvantages of ETFs

Every coin has two sides. It is important to consider ETFs’ potential disadvantages.

1. Liquidity issue

The liquidity of an ETF reflects the liquidity of the underlying basket of shares. Large index ETFs can trade at a high volume, but most ETFs are quite light in trading volume. Low liquidity happened when ETFs have wide bid-ask spreads, low trading volume, and often high volatility (Wayne Duggan). This might make investors more difficult to quickly exit a position at the anticipated price.

(Note: It is important to look at the average trading volume, before adding the ETFs to your portfolio.)

2. Underlying Risks

ETFs' principal is not guaranteed, although ETFs are at lower risk, investors might still lose a significant sum of money in ETFs as ETFs do expose to risks such as market risk, political risk, and currency risk, just like other investments. For example, the Leveraged & Inverse ETF return might be very volatile when the market is in bad condition, which is substantially bad for small investors.

Hence, for investors with a low-risk tolerance, it is essential to read the prospectus carefully and understand what they own and the potential return in the ETFs before making an investment decision. (FSMOne)

3. Underperformance

Based on Stephen Baines, ETFs are meant to track and are still exposed to other factors such as fees, sampling error, trading costs and liquidity preference that potentially caused the underperformed (Simoney Kyriakou). Hence, even in a good year, ETFs might underperform the best stocks in the fund. Meaning investors could have owned just those stocks and done better than in ETFs.

Why ETF over Mutual Fund?

What is Mutual Fund?

A mutual fund is a pooled collection of assets that are professionally managed and invested in collections of securities.

1. ETFs offer greater flexibility

ETFs can be traded intra-day on a stock exchange, in the same way, that regular stock can. While Mutual funds can only be purchased at the end of each trading day, based on their Net Asset Value (NAV).

(Note: Intra-day trading - buying and selling of stocks and other financial instruments within the same trading day before the market closes)

2. Cost-efficient

ETFs offer a lower investment cost than mutual funds, making them more cost-effective. Because mutual funds that are actively managed have higher operating costs, making mutual funds tend to have higher fees and higher expense ratios than passively managed ETFs.

*All figures derive from ETFs’ 2021 Annual Report except for the newly launched fund “CHINA100-MYR” derive from the 2022 Annual Report.

As shown in the table above, the Management Expense Ratio (“MER”) for ETFs listed in Bursa Malaysia from as low as 0.15% p.a. to a maximum of 3.28% p.a. in 2021. Much lower as compared with the fees incurred by the Mutual funds which are up to 5.5% of the upfront sales fee and annual management fee that can be up to 5% p.a. of the fund's NAV as stated on the Bursa Malaysia website.

(Note: formula for MER:

MER = [(Management Fee + Trustee and custodian fees + Auditors’ fee + License fee + Tax agent fee + other expenses) x 100] / Average NAV of the Fund calculated on a daily basis

3. Greater certainty

ETFs typically replicate indices, providing greater certainty than Mutual Funds where the decision to include or exclude particular securities from the portfolio is typically up to the fund manager's discretion and some of the mutual funds only reveal their top ten holdings.

Why ETF over its underlying?

1. ETFs hold a basket of securities and provide diversification benefits

ETFs are made up of dozens of individual stocks and other investments, offering the power of diversification which is able to result in bigger gains as well as smaller losses. The diversification effect will make ETFs more stable than individual stocks.

2. ETFs are less risky than stocks

Individual stocks are riskier and more volatile as compared with ETFs as stock prices can fluctuate daily. While ETFs generally provide a steadier return over time as ETFs aim to track an index but not to outperform the market. Hence, ETFs will generally move less dramatically as ETFs had diversified. (Harlan Vaughn)

3. Time-saving

Investors may find it difficult and time-consuming to analyse each stock individually to decide which stock to invest in. By purchasing ETFs (e.g., ETFs based on the S&P 500), investors can be exposed to 500 publicly traded domestic companies. ETFs that typically offer a diversified allocation can therefore be an excellent choice for investors, as ETFs save investors time that would otherwise be spent analysing trends and stocks. (James Royal)

The Bottom Line

ETFs are a good investment as ETFs provide a more affordable way to hold a collection of securities, where the return is based on the weighted average of all holdings. This makes ETFs an efficient way to increase portfolio flexibility and diversification, which is typically appropriate for:

• Young investors who are just beginning their investment journey and lack financial knowledge and experience
• Investors with busy schedules who lack the time to research and choose investments that are beneficial to their portfolios.

Since each ETF is unique, it is crucial for investors to review the selected ETFs' prospectus and possible risk-return, to see if the selected ETFs good investments that fit investors’ existing portfolio and personal risk tolerance.

References

• Bursa Malaysia. (2022). Exchange Traded Funds (ETFs).
• Bursa Malaysia. FAQs on Exchange Traded Funds (ETFs)
• FSMOne, ETFs.
• Harlan Vaughn. (February 2022). Why Investing in ETFs Is a Better Strategy Than Picking Individual Stocks, According to Experts.
• Ivonne A. Liebenberg. (May 2019). The Effect of Diversification under Different Ownership Structures and Economic Conditions: Evidence from the Great Recession.
• James Royal. (April 2022). Stocks vs. ETFs: Which should you invest in?
• Jen-Li Lim. (2021). A Beginner’s Guide To Investing In ETFs In Malaysia.
• Kevin Voigt & Alana Benson. (September 2022). What Is an Exchange Traded Fund (ETF)?
• Martin J. Pring. (2006). The Investor's Guide to Active Asset Allocation: Using Technical Analysis and ETFs to Trade the Markets.
• Simoney Kyriakou. (April 2022). Four reasons why bond ETFs underperform the index.
• Wayne Duggan. (January 2022). Exchange-Traded Fund (ETF) Definition.

Author

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This article is written by Looi Shin Nye, Research Analyst Intern

Looi Shin Nye is currently majoring in Finance and Investment at Tunku Abdul Rahman University of Management and Technology (TAR UMT). Shin Nye joined TED Optimus Sdn Bhd for 3 months as an intern, responsible for research work and article writing. She participates in Bursa Malaysia Derivatives Virtual Trading Challenge 2021. She is an in-house author from TED Optimus.