ETFs prove resilient in bear market

ETFs prove resilient in bear market

Written by Tho Li Ming

In 2008, fund flows largely went into cash and out of financial products. But despite the doom and gloom, funds continued to flow into exchange-traded funds (ETFs).

“Reports over the past few months indicate that net investment flows into ETFs have been positive (compared with actively-managed funds with net outflows) despite the overall market having gone through the turbulent period,” says Zainal Izlan Zainal Abidin, CEO and director of i-VCAP Management Sdn Bhd, the company managing Syariah-compliant MyETF. Lipper has reported that Europe, there was a net sales outflow of US$125 billion from mutual funds in the first eight months of 2008, while net sales of ETFs were a positive US$48 billion. “ETFs have proven popular with investors in both bear and bull markets. According to Morgan Stanley’s ETFs Global Review — Year End 2007, ETFs’ global assets grew from US$105 billion in 2001 to over US$797 billion by end-2007, representing a remarkable annual growth rate of 39%,” says Jane Leung, senior director of product, iShares Asia ex-Japan, Barclays Global Investors.

The ETFs have performed well as an industry thus far because there are a lot of substitutions going on, says Joseph Ho, managing director and head of ETF sales and marketing at Societe Generale. “There may not be new money (being injected into the market). Instead, money that is exiting individual stocks and traditional unit trust funds is being redeployed into ETFs.”

Why the popularity?

Introduced this millennium, ETFs have sprouted like mushrooms. Leung says ETF assets under management have grown rapidly since the fi rst US ETF was launched in 1993. Ho says ETFs have one well and are continuing to do well because of liquidity and transparency. “It’s also because of the simplicity of diversification with the ETFs — if you want to have some exposure, you want to hold the whole market rather than a single stock in times like these.”

ETFs are similar to conventional unit trust funds in that they can provide diversifi cation with a smaller investment amount, and enable investors to play whole sectors, indices or selected commodities such as gold. Says Ho: “We have gone through a very difficult and confusing year [2008]. Instead of focusing on what to buy this year, go back and look at a more diversified portfolio. A year ago, you would not have been able to invest in gold conveniently. However, these are all possible now in Singapore and Hong Kong. There were a lot of movements within the ETF markets in general. Prior to 2008, the most popular ones were emerging market ETFs but now they [investors] are going into bond ETFs, currency ETFs, broad market ETFs covering regions and countries, and even commodity ETFs.”

Christopher Soon, an institutional consulting director with a major bank in Singapore, recommends investing in ETFs that have exposure to the entire country’s indices such as the iShares MCSI UK Index, iShares MCSI Australia Index, iShares MCSI UK Index and iShares MCSI Malaysia Index. “This way, Malaysian investors do not need to be savvy about ETFs — they just need to be bullish on the country that they are investing in.”

ETFs also come with minimal costs and access to up-to-the-minute trading times, which means that investors can also be more nimble. However, note that they also come with their fair share of risks. For one, there is investment risk in its underlying securities. Soon gives an example. “A fi nancial-sector ETF would be totally exposed to the sell-off in banks and financials. Even a well-diversified index like the S&P would have suff ered versus an active manager who may have decided to underweight financials and overweight defensive sectors like consumer staples during a recession.”

Tracking errors happen when the performance of the ETF does not mimic the performance of thebenchmark index it is tracking. “Even if the index is down 50%, the ETFs should also be down 50%. Tracking error happens when the benchmark is down 50% but the ETFs are down 60% instead. Something is wrong,” says Zainal. “It could be the manager’s fault or something else. In any case, that is the risk. Tracking errors will occur — but the job of the manager is to minimise them,” he adds.

As the ETFs are openly traded on an exchange as opposed to being valued at the end of the day as with unit trust funds, says Soon, they can suffer or benefit from investor sentiment as the traded price differs from their actual net asset value (NAV).

Investing in ETFs

While there are only three listed ETFs on the local stock market, investing in international ETFs is possible. You can ask a local broker for its overseas counterpart, who would be able to perform the trading and transactions, says Zainal. “Investors will still need to open a local version of the CDS account - it’s just like trading on Bursa Malaysia. But there are [other] things [to consider], like settlement issues. For instance, if you’re buying a Hong Kong ETF, you would have to settle in HK dollars and if your funds are in Malaysia, you have to arrange for a remittance or transfer from there.

“For smaller retail investors, it might be too cumbersome, but for those who have international investments to start with, it can be part and parcel of their investments.”Before you buy an ETF, there are some things you need to note. Eric Wong, head of research, Hong Kong at Thomson Reuters Lipper, says retail investors will need to look at, among other things, the assets (stocks, bonds or commodities) the ETFs hold or the indices they track; the investment management style of the ETFs (active or passive); the track record of the financial institutions in designing and developing the ETFs, which includes evaluating the academic qualification and experience of the personnel; and the turnover of investment personnel at the financial institutions, which could result in insuffi cient supervision and subject them to a higher probability of loose management. “Compare the historical and forward fundamental parameters such as price-to-earnings and priceto-book ratios and study the technical trading parameters such as price behaviour pattern, moving averages or Relative Strength Index of the ETFs to determine their entry and exit,” says Wong.

The ETF’s liquidity is also important in order to speed up transactions. Wong says the liquidity of an ETF is not only reflected by its trading volume and bid-ask spread (a narrower spread usually means higher liquidity) at the stock exchange, it is also judged by the liquidity of its underlying securities or the securities that make up the index the ETF tracks.

“Th is is because ETFs sometimes allow their investors, usually institutional investors, to redeem large blocks of the ETF units for a basket of the underlying assets [securities] of the ETFs, or alternately, exchange the underlying securities for the ETF units. “Thus, the liquidity of these underlying securities also determines the liquidity of the ETF and needs to be considered,” he adds.

Lastly, watch out for those fees. Just like unit trust funds, management fees vary for different types of ETFs. “Some underlying securities are easier to access than others. If you want those that are more diffi cult to access, be prepared to pay more,” says Zainal.