Saturday, May 24, 2008

Investing in Exchange Traded Funds (ETF)

Exchange Traded funds are special type of funds that invests in a portfolio of stocks/bonds/commodities that are designed to mimic as closely as possible the performance of a specified index. In the case of the Singapore Straits Times Index, there is a STI ETF under streetTRACKS. The STI ETF is traded like normal stocks and shares.

Advantages of ETF
  • Means of diversification whereby a single transaction yields exposure to an entire index or sector.
  • Can be traded throughout the day like shares unlike open-end funds that only trade once a day at prices determined at the close of the market.
  • Some ETFs are patterned after indexes that have active options and futures thus allowing for better risk management
  • One knows the exact composition of the fund at all times
  • Being passively managed, ETFs have a very small expense ratio with no loads to purchase or redeem the shares.
  • No trading at discount or premium to NAV (though this happens sometimes
Disadvantages of ETF
  • Ability to trade ETF intraday may not be significant as some investors are in for the longer time horizon
  • Inefficient markets exist with large bid-ask spreads in those ETF with low trading volume.
  • Larger investors might choose to invest directly in an index portfolio resulting in lower expense and lower tax consequences.
Risks of ETF
  • Currency and Country Risk
  • Some ETFs are able to purchase derivatives. Additional risk from increased leverage as well as credit risk on derivatives
  • Trading prices of ETFs can differ from NAV, depending upon depth and liquidity of market.
  • Tracking error risk where portfolio is not identifcal to the benchmark index and does not perform identically to the index.
  • Subjected to asset class or sector risk.
  • Market risk of the index tracked by the ETF

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