Investors will soon have another investment alternative, with the imminent launch of ETF or Exchange Traded Funds. Earlier this year, the Philippine Stock Exchange (PSE) approved the guidelines governing ETFs and last week, a public forum was held introducing ETFs to the public.

We previously wrote about the basics of ETF investing here, but here are additional details about this new investment product to help investors decide whether ETFs are fit for them.

What are Exchange Traded Funds (ETF)?

An ETF is a managed investment fund that tracks an index or a basket of assets and is traded on an exchange such as the Philippine Stock Exchange. For clarity, let's break down this definition.

Managed Fund

As a managed investment fund, an ETF is similar to mutual funds and unit investment trust funds wherein they are managed by a group of investment managers in the financial institution offering the ETF. The role of the ETF fund managers is to "track" an index or a basket of assets. We discussed in detail the difference of ETFs vs. mutual funds and UITFs in this article.

Tracking an Index

The index that the ETF may track may be any asset index. Initially, this could be the Philippine Stock Exchange index (PSEi), the primary equity index in the Philippines comprised of 30 publicly traded companies in the PSE. By "tracking the index", ETFs are supposed to replicate the performance of the index, hence, ETFs are expected to produce a similar level of return.

ETFs are rarely traded actively, meaning, they are not designed to consistently beat the index. It can then be expected that the returns of ETFs may be somewhat lower compared to the actual performance of the index. That may partly be due to imperfect rebalancing of the index and transaction costs with regard to the trades of the fund.

Traded on the Exchange

The main difference of ETFs versus other managed funds is that ETFs are traded on the exchange, hence the name. Mutual funds and UITFs have end-of-day values - called the Net Asset Value per Share (NAVPS) in the case of mutual funds and Net Asset Value per Unit (NAVPU) in the case of UITFs. These are the prices wherein an investor can purchase or redeem shares or units of these funds. They can only purchase or redeem at the end of the trading day.

ETF, meanehil, is similar to stocks in the sense that its price may vary anytime during the trading day. Since they are traded, investors may buy or sell those ETFs within the day. As per the approved PSE guidelines, ETFs are supposed to issue a real-time value of the fund, to be called the iNav, every fifteen (15) seconds. Hence, investors can know the value of the ETF in real-time and can make decisions (like buy or sell) anytime during the day.

Benefits of ETF Investing

The primary benefit of ETF is diversification. ETFs offer another alternative to those looking for more investment options aside from stocks, bonds, mutual funds or UITFs. Because of diversification, investors may lower the risk of their overall portfolio since they can spread the risk among all investment assets in their portfolio.

For example, if an investor is directly and fully invested in one stock and that stock tumbled in price, the investor stands to lose a certain amount of money. But if the investor is 50% invested in that stock and 50% invested in an ETF, the amount of loss may be lower because the ETF will have a different performance from the stock. That is what is meant by reducing the "portfolio risk".

ETF investors may also benefit from higher income through speculative trading. Like stocks, ETFs will be traded daily and prices may change anytime during the day. This gives traders an opportunity to buy or sell an ETF - within the day - in the hopes of locking in gains due to constant price movements. Traders may also speculate, because if they believe the index or the assets comprising the basket may rise in the future, they can time the market and buy supposedly at a low and sell the ETF later at a higher price.

Another benefit of ETF investing would be the ability to invest in a variety of assets at lower investment cost. No actual ETF product has been launched to the market yet but we expect ETF prices to be initially priced just a few thousand pesos. This makes it easier and cheaper for retail investors to indirectly invest in a variety of assets or stocks.

For example, an investor currently has to shell out around P15,000 just to buy the minimum number of shares of PLDT (stock code: TEL) and around P7,500 in order to buy the minimum shares of Globe Telecom (stock code: GLO). This means, investors already must spend P22,500 just to invest in those two stocks. With ETFs, they can spend P22,500 to indirectly invest in all the underlying assets included in the ETF. If the ETF is tracking the PSEi, ETF investors become indirect investors the 30 companies comprising the index. Thus they get to reap the benefits of investing in all those stocks at a lower cost.

Disadvantages of ETF Investing

In the same way that diversification can lower the overall risk of the portfolio, diversification also tempers the overall return of the investor. For example, if an investor is fully invested in a stock that rose 50% in price, the investor gets to receive the full 50% benefit. In ETFs, if that stock is just one of several stocks being tracked by the index, the return will be lower than 50% because other stocks in that index that underperformed will lower the overall return of the index.

Also, the intraday trading nature of ETFs may not be applicable to long-term investors. Long-term investors with an investment horizon of at least 5-10 years may find the daily prices of ETFs volatile which could lead them to buying and selling ETFs in the short-term, thereby distorting their overall investment objective and strategy.

This volatility in ETF prices may be caused not by fluctuations in the index performance but by speculation and manipulation by a few players hoping to profit from intraday price changes. This could also lead to a wide disparity between the actual index performance and ETF prices. Thus, long-term investors who would simply leave money for some time and who would not trade actively may find blue chip stocks or index mutual funds or UITFs instead to be better suited to their investment objective.

When can we start investing in ETFs?

Probably very soon. Large local financial institutions such as Bank of the Philippine Islands (BPI), Banco de Oro (BDO) and First Metro Investment Securities (FMIC) have disclosed that they are interested to launch ETFs soon. The guidelines have already been approved and released by the PSE, so we can expect now that interested players are now starting to prepare the launch of their ETFs.

By James | PinoyMoneyTalk.com

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