What is Exchange Traded Fund (ETF) & How Does It Work?

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Exchange-traded funds (ETFs) are a great way for anyone who wishes to build a passive investment in a diversified portfolio. It’s an easy entry investment with high return characteristics that make it suitable for both beginner and experienced investors as well. According to the Financial Times, ETFs are set to overtake mutual funds as passive vehicles of choice. Maybe it's a sign for you to start considering it too?

What's covered in this article?

First of all, what is an ETF?

An ETF is an index-tracking investment tool that is traded on a stock market. It combines the features of a Unit Trust, which pools a few investments into a basket and trades on the stock exchange like stocks.

In simple form, investing in an ETF is like going shopping at a hypermarket, where we only put an item in our basket instead of the whole shelf, and in the end, our basket is full of a bunch of products. All the products will be paid for at the same time.

How many types of ETFs are there?

Currently, there are 19 ETFs available on Bursa Malaysia that are divided into several types. Each with a different investment focus, representing different asset classes and different stock exchanges.

They are commodity ETFs, equity ETFs, equity (Shariah-compliant) ETFs, fixed income ETFs, and Leveraged & Inverse ETFs.

1. Commodity ETF

It's an ETF that is invested in physical commodities. A commodity ETF tracks the prices of the commodities that are linked to the ETF. Thus, any investor who invests in a commodity ETF owns a set of contracts backed by the commodity.

For example, Malaysia’s 1st Shariah-compliant Commodity ETF, a TRADEPLUS SHARIAH GOLD TRACKER, is tracked by the gold prices, which 95% of TradePlus Shariah Gold Tracker is backed by physical gold purchased only from gold refiners accredited by the London Bullion Market Association (“LBMA”). It allows investors to invest in gold without the hassle of storing the gold.

2. Equity ETFs and Equity (Shariah-compliant) ETFs

Both share the same characteristic where they pool a few securities of the same industry or the top traded stocks instead of buying just 1 company.

For example, FBM KLCI ETF tracks the performance of FTSE Bursa Malaysia KLCI, which provides exposure to the top 30 listed companies on Bursa Malaysia. Investing in this ETF is like buying a small portion of the Malaysian equity market performance.

3. Fixed Income ETFs

It's a portfolio of mainly Malaysian government bonds. The fixed income ETF available on Bursa Malaysia is ABF MALAYSIA BOND INDEX FUND. The return is closely tracked by the performance of the bonds.

4. Leveraged & Inverse ETFs

Leverage is a technique that amplifies an investor’s profits or losses. Thus, a leveraged ETF is to provide investors with the amplification of returns on the index's daily performance. TRADEPLUS NYSE FANG+ DAILY (2X) LEVERAGED TRACKER.

For example, if the market index rises by 1% on a given day, then a 2x leveraged ETF should rise by 2% on that day. Vice versa on the downfall of the market, as if the market index falls by 1% on a given day, then a 2x leveraged ETF should also fall by 2% on that day.

Meanwhile, the definition of the word inverse is the opposite. Thus, an inverse ETF means the fund will provide a return with the opposite of what is reflected in the index's daily performance.

For example, KENANGA KLCI DAILY (-1X) INVERSE ETF, if the market index rises by 1% on a given day, then a 2x inverse ETF should fall by 2% on that day. Vice versa on the downfall of the market as if the market index falls by 1% on a given day, then a 2x inverse ETF should also rise by 2% on that day.

How about the returns on ETF Investment?

Frankly speaking, every investor invests with returns in mind. There are 2 types of returns that can be gained from investing in an ETF.

The first is capital gains, where you can buy an ETF at a lower price and sell it later at a higher price. The profit is called a capital gain, which you get from the price differences.

Next is dividends. Fund managers usually receive dividends from the securities that comprise the respective ETFs pool. The dividends are usually distributed to ETF unitholders following the deduction of the management fee.

Investing in an ETF, returns are highly dependent on the ETF’s geography or the asset class.
For example, for commodities, if you're investing in a TRADEPLUS SHARIAH GOLD TRACKER ETF. It provides a Shariah-compliant investment facility in physical gold without the hassle of storing or insuring gold bullion. Hence, your returns will mirror the returns of gold through an exchange-traded fund structure.

If you invest in an Equity ETF such as MYETF DOW JONES ISLAMIC MARKET MALAYSIA TITANS 50, your returns will mirror the performance benchmark of the 50 largest companies by float-adjusted market capitalisation listed on the Dow Jones, which have passed rules-based screens for Shariah compliance.

Why do investors decide to put their money into an ETF?

1. Diversification and Risk Aversion

ETF is often mistaken for Unit trusts, as it also represent partial ownership of a portfolio that is being pooled together. The inventors are able to benefit from diversification and security, which helps in averting the risk involved in owning stock from a single company.

2. Liquidity

ETFs are behaving like stocks; they are traded intraday on the stock market at real-time prices, where prices are determined by supply and demand factors. Plus, investors can redeem units easily and obtain cash by the 2nd market day after the trade date (T+2).

3. Affordability

Unlike a unit trust, there is no minimum investment in ETFs. Thus, an investor can purchase as little as 1 lot (100 units).

For example, an ETF entry amount depends on the market price x 1 lot. As of 14 October 2021, the FTSE BURSA MALAYSIA KLCI ETF price is listed at 1.67. So, RM1.67 x 1 lot (100 units) is RM167. That's the entry amount for 1 lot of the ETF.

As you can see, the lower entry investment makes it much easier for people to invest in ETFs.

4. Cost-Effective

ETFs imposed lower annual management fees and no upfront fees.

5. Simplicity and Transparency

ETFs are listed on the Main Market of Bursa Malaysia. Thus, the buying and selling process of ETF units can be done both online and through stockbrokers. It will be based on its current market price. In addition, investors can determine what stocks are held by the ETF by visiting its website, provided by their respective fund manager website, or on the Bursa Website. The ETF list is updated on a daily basis.

What are the drawbacks of investing in ETFs?

The same goes for all investments; there are risks and drawbacks that need to be considered before investing.

1. Mistiming Tendency

The simplicity and flexibility of ETF trading may encourage frequent trading. This could lead to mistiming in buying or selling ETFs. In addition, the performance of an ETF may be directly affected by the performance of its component stocks or bonds.

2. Charges

There are also several charges imposed, which are similar to stocks, which are brokerage commission, stamp duty, and clearing fees, where applicable.

3. Risk Exposure

Investing in an exchange-traded fund (ETF) offers exposure to the whole industry. For example, the Principal FTSE China 50 ETF tracks the top 50 largest Chinese stocks listed and traded on the Hong Kong Stock Exchange. So, if any political or geographical disaster happens that affects the country. Most likely, all companies that were tracked for the ETF will be affected as well.

How to invest in an ETF?

Let's get to business, in order to place your first purchase on an ETF, similarly to trading stocks. You will be required to have a Central Depository System (CDS) account and a trading account maintained with any broker. In order to open a CDS account, one needs to complete by signing a security account opening/maintenance form with your Central Depository Agent (CDA) via investment banks. There are also Investment Institutions that provide online applications, such as Maybank Investment and Rakuten.

Next, you can place your order to buy or sell ETFs through your broker, a remisier (like a sub-broker), or via online trading during trading hours. They are traded on Monday to Friday from 9 am to 5 pm (with a 12.30 pm to 2.30 pm break session). ETF prices are available on the Bursa Malaysia page.

So, is ETF a suitable investment product for you?

ETFs enable investors to implement passive investment strategies in the portfolio. Not only are they low in costs, but their diversified exposure to the markets adds value in maximising returns at any given level of risk. Their variety of asset classes and geographical coverage gives you the flexibility to face any economic environment. However, always study and do your research on each type of ETF or any investment medium before placing your money into it.

*The above article is intended for informational purposes only. Loanstreet accepts no responsibility for loss that may arise from reliance on information contained in the articles.

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