Report from The Business Times (Singapore) dated Fri, Dec 24, 2010
What to invest your money in
By Genevieve Cua
THE process of picking investments for a portfolio may be a bewildering exercise.
You are faced with more than a thousand unit trusts and insurance funds. There are also nearly 80 exchange traded funds (ETFs), plus even a fairly new instrument called exchange traded notes (ETNs).
How do you go about selecting instruments that are appropriate for your needs?
This edition of Smart Money gives an overview of the various instruments available and how they may make sense for you. The specific underlying investments and exposures will vary, of course, and it will be up to you and your adviser - if you have one - to decide on the combination of exposures and instruments to invest in.
The structure of the vehicle you may choose - whether unit trust, investment-linked insurance fund (ILP) or ETF - is an important decision as well, as it may have a bearing on costs, liquidity and risks.
Here are some basic definitions and points to consider on each instrument.
UNIT TRUSTS
Unit trusts are unitised investment funds that pool together investors' monies to invest in assets such as stocks and bonds.
They are typically professionally and actively managed, which makes them ideal for retail investors who may not have enough funds to buy assets directly and still achieve diversification. They are also appropriate for those who do not have the time or inclination to do their own research on individual stocks and bonds.
Unit trusts are typically sold through banks and financial advisers. Investors who are self-directed can also buy or sell funds through fund supermarket portals.
The mode of investment in unit trusts - and generally any other pooled investment such as ETFs or ILPs - can be through a single lump sum or, in the case of unit trusts or ILPs, through a regular investment plan, which can be as frequently as monthly or quarterly.
A regular investment plan is typically recommended for a long-term investor as it encourages discipline and reduces the timing risk. This is because by committing to invest a pre-determined amount regularly over a period, you automatically buy more units when the market is down and less when the market is high.
This is part of the essence of investing by 'dollar cost averaging'. ETFs do not have regular savings plans as purchases are made on the secondary market in fixed lot sizes, as opposed to transacting on the primary market in fixed dollar amounts.
Unit trusts will incur costs, including annual management fees, trustee fees and sales charges. Liquidity is typically not an issue as units are cancelled or created when there is a sale or purchase. There is usually daily fund valuation to come up with a net asset value. But when you buy or sell units, you may not immediately know your purchase or sale price. Instead, you transact based on a forward valuation - the next working day's value.
INVESTMENT-LINKED INSURANCE FUNDS
ILPs are also pooled and professionally managed investment funds, but with insurance cover.
They are typically sold through insurance advisers, and sometimes through banks.
Insurance companies offer ILPs to give policyholders the flexibility to set their own asset allocation and exposures within an insurance policy. There are currently ILPs that offer nearly zero protection, and those who invest in a lump sum or single premium can view it almost like a unit trust.
The big differences between ILPs and unit trusts lie in the insurance coverage itself. Regular premium ILPs in particular may be whole-life policies or a long-term savings plan for a child's future education expenses. Such policies seek two objectives - to provide protection as well as savings growth over the medium to long term.
While many insurers offer ILPs that feed into unit trusts, ILP funds are actually not trust structures. While there will be annual management fees, there is no trustee; nor is there a prospectus. However, ILPs do have a product summary that contains information similar to that in a prospectus.
Yet another very important thing to note about ILPs is the costs. The insurance coverage will have its own set of charges, including the cost to provide a death benefit; and also a policy fee which is an annual administrative charge for regular premium plans. These fees are not calculated as part of the underlying investment fund's total expense ratio.
It is best to ask your insurance adviser to itemise these costs, particularly the cost of insurance. The latter is usually deducted by cancelling fund units. The older you get, the more costly the cover gets, and you may well find that with time, a larger portion of your premium is actually funding mortality charges rather than investments.
There are also distribution costs. These will be clearly stated in the benefit illustration. For example, it is possible that the bulk of your first-year premium is going to the agent's commission, and annual premiums are fully invested in fund units only from the fourth year.
You should also be aware of the sales charge, which is typically 5 per cent. Your premium will buy fund units at the offer price. Units are cancelled to fund expenses such as insurance costs at the bid price.
EXCHANGE TRADED FUNDS
Exchange traded funds (ETFs). These are actually unit trusts that are listed on the exchange.
ETFs are traded through a broker who will charge a commission for transactions, similar to share trading.
The advantage of a listing is that prices are transparent and easy to track. You also transact at a known price, unlike unit trusts and ILPs where you may not immediately know the sale or purchase price.
Unlike unit trusts and ILPs, however, an ETF's traded price may deviate from its net asset value due to a number of factors including market demand.
The specific market exposure of an ETF will vary widely, and you should be prepared to take on that particular market risk. There may also be currency risk if the ETF is denominated in a foreign currency.
On liquidity, ETFs will have market makers to ensure liquidity, but those that are thinly traded may have fairly wide bid/ask spreads, which effectively raises your transaction costs. ETFs are traded through brokers, who will charge a brokerage fee.
A big distinction of ETFs from unit trusts and ILPs is that the ETFs are typically passive index tracking instruments. Hence, total expense ratios of ETFs will be a fraction of actively managed funds. Most unit trusts and ILPs are actively managed funds and management fees can exceed 2 per cent for equity funds, for instance. With ETFs, the management fee can be as low as 0.18 per cent.
The structure of ETFs can also vary, and may be complex to boot. One type of ETF invests directly in the assets that represent an index; another type is synthetic - that is, the exposure is achieved through derivatives such as swap contracts. Synthetic ETFs will involve counterparty risks which can be mitigated to some extent. Some unlisted unit trusts can have these complex structures and market risks too. If a particular structure is too complex for you to understand, it may be best not to invest.
EXCHANGE TRADED NOTES
Exchange traded notes (ETNs). An ETN is a debt instrument where investment exposure and returns may be linked to a market index or to a single commodity. ETFs, in contrast, typically do not provide exposure to a single asset.
At the moment there is just one ETN listed on the SGX, linked to commodities. Because ETNs' exposure is to a market index, investors may confuse the instrument with ETFs. In reality ETNs present quite a different basket of risks, even though the investment theme - be it commodities or an equity market return - may be similar to ETFs.
The big thing to remember about ETNs is that they are a debt instrument. Most ETNs are long dated, with a maturity of about 30 years or longer. The ETN listed on SGX, for instance, will mature in 2036. Investors are free to sell on the exchange through a broker or redeem the ETN with the issuer in a large block of securities. But they could also choose to hold it to maturity and receive the return linked to index after fees at that point in time. There is no guarantee of principal; and no dividend or coupon payments.
While ETFs are backed by securities held in trust, or by a collateral arrangement, ETNs are usually not. This is a major distinction from ETFs, where investors own a pro-rated share of assets in a trust. With ETNs, there are no assets to back up the note, and the issuers can use the funds raised for their own purposes, including business expansion as well as hedging their exposure to the ETN itself.
By investing in ETNs, you are effectively also banking on the credit quality of the issuer. ETNs themselves are typically not rated, but the issuer will have a rating, which will be disclosed in documentation. You have to be cognisant of the credit risks; a deterioration in the credit quality of the issuer could cause the ETN's price to drop, even if the index to which it is linked remains sound and positive. You may also lose part or all of your investment if the issuer defaults on its obligations under the ETNs.
Exchange traded notes a good choice for small investor
EXCHANGE traded notes (ETNs) are a way for investors to access a variety of investment markets including commodities and equities. But while investors may think they are similar to ETFs (exchange traded funds), ETNs are actually quite a different vehicle.
ETNs are debt instruments; they are senior unsecured debt issued by an institution, typically with a very long maturity. Unlike corporate bonds, however, they are structured to provide a return linked to a range of assets, which can be equity, commodity or interest rate indices.
As such, they provide a convenient way to access markets when you have a relatively modest sum to invest, or when those markets are difficult to access.
Among ETNs' advantages are an exchange listing, which makes prices transparent and easy to track.
There are also market makers to help provide liquidity.
Here are a number of major characteristics of ETNs:
ETNs versus corporate bonds. Corporate bonds are issued by institutions to raise capital for various purposes, which will be explained in issue documents. ETNs are also issued by institutions to raise funds for corporate purposes and for hedging their exposure to the ETN. The portion used for hedging, says Jin-Chuan Duan, is likely to be relatively small. Professor Duan is director of the Risk Management Institute and Cycle & Carriage Professor of Finance at the National University of Singapore. 'It's safe to assume that the funds will in large part be for corporate use.'
Unlike bonds, the issuers of ETNs will not pay a coupon, and they collect management fees to boot. ETNs are actually riskier than corporate bonds as the investor takes on market risk - that is, the return and principal amount payable when the investor sells or redeems the note will depend on the performance of the market index to which it is linked. In contrast, corporate bonds' payment of coupon and return of principal do not depend on the behaviour of any market index.
Credit risk. This is a second major risk. Just as with corporate bonds, you will need to be mindful of the credit risk of the ETN issuer. The issuer's credit rating is typically specified in an ETN's prospectus. Note there is no credit rating on the note itself. A credit downgrade may cause the ETN's price to fall even if the underlying market to which the note is linked remains sound.
'One important lesson from the financial crisis of 2008-2009 is that big financial institutions can go bust,' says Prof Duan.
Liquidity. Prof Duan says liquidity risk deserves special attention. Using the iPath DJ-UBS Commodity Index ETN as an example, investors can expect to realise a return before the note's maturity in 2036 by selling on the exchange or redeeming the note through the issuer, Barclays.
'Redemption requires a minimum of a large block of securities and is unlikely to be applicable to small investors. One should not be surprised to see very little trading volume on ETNs. Thus, the liquidity risk of ETNs is generally quite significant,' says Prof Duan.
No tracking error. One advantage of ETNs is that there is zero tracking error or deviation between the note's indicative value and the index. At redemption or maturity, the investor should receive the return linked to the index less a management fee.
UTs, ILPs, ETFs, ETNs: Pick what suits you
THE alphabet soup of acronyms denoting investment vehicles can be confusing. Are UTs (unit trusts) right for you? Or perhaps ILPs (investment-linked insurance plans); or maybe it's ETFs (exchange-traded funds) or ETNs (exchange-traded notes)?
Before you get tied up in knots, it's important to ascertain your own objectives. Are you saving for a long-term goal, or taking an opportunistic short-term bet? Be familiar too with your current holdings, as it is possible that a UT or an ETF may actually hold securities that you already own directly.
If sleeping well is important to you, you will want to be diversified. Diversification may not yield the best returns at any point in time, but it should cushion you through market volatility.
UTs, ETFs and ILPs lend themselves to a long-term portfolio. They can be complementary: ETFs generally give broad market returns, and UTs in theory should generate returns better than an index, which is why you pay higher fees.
One common approach, particularly among institutions, is to use ETFs for core allocations. On the periphery, you could take higher risks through actively managed funds or funds with more concentrated exposures.
ILPs may be seen mainly as investment instruments if the insurance cover is minimal. This is the case if you are investing in a single-premium mode. But a regular-premium ILP is probably best viewed as a protection plan.
As an investment, it is inefficient because of the relatively high costs that are external to the underlying funds - such as mortality charges. These costs will reduce the expected annualised return substantially.
This is evident when you examine the plan's 'reduction in yield' which may be itemised in any benefit illustration. For example, a regular-premium plan for a 35-year-old male with a death benefit of $200,000 - using a simple balanced fund as the underlying investment - may see a net expected annualised return of 5.37 per cent, from a theoretical 9 per cent gross return over 20 years. This suggests that annual expenses could exceed 3.6 per cent.
ETNs are debt instruments with a market exposure. If you are unfamiliar with them, or are uncomfortable with the credit quality of the issuer, it may be best to refrain from investing in them. It is argued that ETNs may have a place in a portfolio as their tracking error - the extent to which the ETNs deviate from the index - is zero. But ETFs offer low tracking errors as well.
Corporate bonds may be more suitable for investors who want a regular coupon and their principal at maturity, while ETNs are for investors who are willing to undertake the market risks of ETNs to achieve potentially higher returns. And, if you want a pure exposure to an index, you can generally get it through an ETF.
This article was first published in The Business Times.
What to invest your money in
By Genevieve Cua
THE process of picking investments for a portfolio may be a bewildering exercise.
You are faced with more than a thousand unit trusts and insurance funds. There are also nearly 80 exchange traded funds (ETFs), plus even a fairly new instrument called exchange traded notes (ETNs).
How do you go about selecting instruments that are appropriate for your needs?
This edition of Smart Money gives an overview of the various instruments available and how they may make sense for you. The specific underlying investments and exposures will vary, of course, and it will be up to you and your adviser - if you have one - to decide on the combination of exposures and instruments to invest in.
The structure of the vehicle you may choose - whether unit trust, investment-linked insurance fund (ILP) or ETF - is an important decision as well, as it may have a bearing on costs, liquidity and risks.
Here are some basic definitions and points to consider on each instrument.
UNIT TRUSTS
Unit trusts are unitised investment funds that pool together investors' monies to invest in assets such as stocks and bonds.
They are typically professionally and actively managed, which makes them ideal for retail investors who may not have enough funds to buy assets directly and still achieve diversification. They are also appropriate for those who do not have the time or inclination to do their own research on individual stocks and bonds.
Unit trusts are typically sold through banks and financial advisers. Investors who are self-directed can also buy or sell funds through fund supermarket portals.
The mode of investment in unit trusts - and generally any other pooled investment such as ETFs or ILPs - can be through a single lump sum or, in the case of unit trusts or ILPs, through a regular investment plan, which can be as frequently as monthly or quarterly.
A regular investment plan is typically recommended for a long-term investor as it encourages discipline and reduces the timing risk. This is because by committing to invest a pre-determined amount regularly over a period, you automatically buy more units when the market is down and less when the market is high.
This is part of the essence of investing by 'dollar cost averaging'. ETFs do not have regular savings plans as purchases are made on the secondary market in fixed lot sizes, as opposed to transacting on the primary market in fixed dollar amounts.
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Unit trusts will incur costs, including annual management fees, trustee fees and sales charges. Liquidity is typically not an issue as units are cancelled or created when there is a sale or purchase. There is usually daily fund valuation to come up with a net asset value. But when you buy or sell units, you may not immediately know your purchase or sale price. Instead, you transact based on a forward valuation - the next working day's value.
INVESTMENT-LINKED INSURANCE FUNDS
ILPs are also pooled and professionally managed investment funds, but with insurance cover.
They are typically sold through insurance advisers, and sometimes through banks.
Insurance companies offer ILPs to give policyholders the flexibility to set their own asset allocation and exposures within an insurance policy. There are currently ILPs that offer nearly zero protection, and those who invest in a lump sum or single premium can view it almost like a unit trust.
The big differences between ILPs and unit trusts lie in the insurance coverage itself. Regular premium ILPs in particular may be whole-life policies or a long-term savings plan for a child's future education expenses. Such policies seek two objectives - to provide protection as well as savings growth over the medium to long term.
While many insurers offer ILPs that feed into unit trusts, ILP funds are actually not trust structures. While there will be annual management fees, there is no trustee; nor is there a prospectus. However, ILPs do have a product summary that contains information similar to that in a prospectus.
Yet another very important thing to note about ILPs is the costs. The insurance coverage will have its own set of charges, including the cost to provide a death benefit; and also a policy fee which is an annual administrative charge for regular premium plans. These fees are not calculated as part of the underlying investment fund's total expense ratio.
It is best to ask your insurance adviser to itemise these costs, particularly the cost of insurance. The latter is usually deducted by cancelling fund units. The older you get, the more costly the cover gets, and you may well find that with time, a larger portion of your premium is actually funding mortality charges rather than investments.
There are also distribution costs. These will be clearly stated in the benefit illustration. For example, it is possible that the bulk of your first-year premium is going to the agent's commission, and annual premiums are fully invested in fund units only from the fourth year.
You should also be aware of the sales charge, which is typically 5 per cent. Your premium will buy fund units at the offer price. Units are cancelled to fund expenses such as insurance costs at the bid price.
EXCHANGE TRADED FUNDS
Exchange traded funds (ETFs). These are actually unit trusts that are listed on the exchange.
ETFs are traded through a broker who will charge a commission for transactions, similar to share trading.
The advantage of a listing is that prices are transparent and easy to track. You also transact at a known price, unlike unit trusts and ILPs where you may not immediately know the sale or purchase price.
Unlike unit trusts and ILPs, however, an ETF's traded price may deviate from its net asset value due to a number of factors including market demand.
The specific market exposure of an ETF will vary widely, and you should be prepared to take on that particular market risk. There may also be currency risk if the ETF is denominated in a foreign currency.
On liquidity, ETFs will have market makers to ensure liquidity, but those that are thinly traded may have fairly wide bid/ask spreads, which effectively raises your transaction costs. ETFs are traded through brokers, who will charge a brokerage fee.
A big distinction of ETFs from unit trusts and ILPs is that the ETFs are typically passive index tracking instruments. Hence, total expense ratios of ETFs will be a fraction of actively managed funds. Most unit trusts and ILPs are actively managed funds and management fees can exceed 2 per cent for equity funds, for instance. With ETFs, the management fee can be as low as 0.18 per cent.
The structure of ETFs can also vary, and may be complex to boot. One type of ETF invests directly in the assets that represent an index; another type is synthetic - that is, the exposure is achieved through derivatives such as swap contracts. Synthetic ETFs will involve counterparty risks which can be mitigated to some extent. Some unlisted unit trusts can have these complex structures and market risks too. If a particular structure is too complex for you to understand, it may be best not to invest.
EXCHANGE TRADED NOTES
Exchange traded notes (ETNs). An ETN is a debt instrument where investment exposure and returns may be linked to a market index or to a single commodity. ETFs, in contrast, typically do not provide exposure to a single asset.
At the moment there is just one ETN listed on the SGX, linked to commodities. Because ETNs' exposure is to a market index, investors may confuse the instrument with ETFs. In reality ETNs present quite a different basket of risks, even though the investment theme - be it commodities or an equity market return - may be similar to ETFs.
The big thing to remember about ETNs is that they are a debt instrument. Most ETNs are long dated, with a maturity of about 30 years or longer. The ETN listed on SGX, for instance, will mature in 2036. Investors are free to sell on the exchange through a broker or redeem the ETN with the issuer in a large block of securities. But they could also choose to hold it to maturity and receive the return linked to index after fees at that point in time. There is no guarantee of principal; and no dividend or coupon payments.
While ETFs are backed by securities held in trust, or by a collateral arrangement, ETNs are usually not. This is a major distinction from ETFs, where investors own a pro-rated share of assets in a trust. With ETNs, there are no assets to back up the note, and the issuers can use the funds raised for their own purposes, including business expansion as well as hedging their exposure to the ETN itself.
By investing in ETNs, you are effectively also banking on the credit quality of the issuer. ETNs themselves are typically not rated, but the issuer will have a rating, which will be disclosed in documentation. You have to be cognisant of the credit risks; a deterioration in the credit quality of the issuer could cause the ETN's price to drop, even if the index to which it is linked remains sound and positive. You may also lose part or all of your investment if the issuer defaults on its obligations under the ETNs.
Exchange traded notes a good choice for small investor
EXCHANGE traded notes (ETNs) are a way for investors to access a variety of investment markets including commodities and equities. But while investors may think they are similar to ETFs (exchange traded funds), ETNs are actually quite a different vehicle.
ETNs are debt instruments; they are senior unsecured debt issued by an institution, typically with a very long maturity. Unlike corporate bonds, however, they are structured to provide a return linked to a range of assets, which can be equity, commodity or interest rate indices.
As such, they provide a convenient way to access markets when you have a relatively modest sum to invest, or when those markets are difficult to access.
Among ETNs' advantages are an exchange listing, which makes prices transparent and easy to track.
There are also market makers to help provide liquidity.
Here are a number of major characteristics of ETNs:
ETNs versus corporate bonds. Corporate bonds are issued by institutions to raise capital for various purposes, which will be explained in issue documents. ETNs are also issued by institutions to raise funds for corporate purposes and for hedging their exposure to the ETN. The portion used for hedging, says Jin-Chuan Duan, is likely to be relatively small. Professor Duan is director of the Risk Management Institute and Cycle & Carriage Professor of Finance at the National University of Singapore. 'It's safe to assume that the funds will in large part be for corporate use.'
Unlike bonds, the issuers of ETNs will not pay a coupon, and they collect management fees to boot. ETNs are actually riskier than corporate bonds as the investor takes on market risk - that is, the return and principal amount payable when the investor sells or redeems the note will depend on the performance of the market index to which it is linked. In contrast, corporate bonds' payment of coupon and return of principal do not depend on the behaviour of any market index.
Credit risk. This is a second major risk. Just as with corporate bonds, you will need to be mindful of the credit risk of the ETN issuer. The issuer's credit rating is typically specified in an ETN's prospectus. Note there is no credit rating on the note itself. A credit downgrade may cause the ETN's price to fall even if the underlying market to which the note is linked remains sound.
'One important lesson from the financial crisis of 2008-2009 is that big financial institutions can go bust,' says Prof Duan.
Liquidity. Prof Duan says liquidity risk deserves special attention. Using the iPath DJ-UBS Commodity Index ETN as an example, investors can expect to realise a return before the note's maturity in 2036 by selling on the exchange or redeeming the note through the issuer, Barclays.
'Redemption requires a minimum of a large block of securities and is unlikely to be applicable to small investors. One should not be surprised to see very little trading volume on ETNs. Thus, the liquidity risk of ETNs is generally quite significant,' says Prof Duan.
No tracking error. One advantage of ETNs is that there is zero tracking error or deviation between the note's indicative value and the index. At redemption or maturity, the investor should receive the return linked to the index less a management fee.
UTs, ILPs, ETFs, ETNs: Pick what suits you
THE alphabet soup of acronyms denoting investment vehicles can be confusing. Are UTs (unit trusts) right for you? Or perhaps ILPs (investment-linked insurance plans); or maybe it's ETFs (exchange-traded funds) or ETNs (exchange-traded notes)?
Before you get tied up in knots, it's important to ascertain your own objectives. Are you saving for a long-term goal, or taking an opportunistic short-term bet? Be familiar too with your current holdings, as it is possible that a UT or an ETF may actually hold securities that you already own directly.
If sleeping well is important to you, you will want to be diversified. Diversification may not yield the best returns at any point in time, but it should cushion you through market volatility.
UTs, ETFs and ILPs lend themselves to a long-term portfolio. They can be complementary: ETFs generally give broad market returns, and UTs in theory should generate returns better than an index, which is why you pay higher fees.
One common approach, particularly among institutions, is to use ETFs for core allocations. On the periphery, you could take higher risks through actively managed funds or funds with more concentrated exposures.
ILPs may be seen mainly as investment instruments if the insurance cover is minimal. This is the case if you are investing in a single-premium mode. But a regular-premium ILP is probably best viewed as a protection plan.
As an investment, it is inefficient because of the relatively high costs that are external to the underlying funds - such as mortality charges. These costs will reduce the expected annualised return substantially.
This is evident when you examine the plan's 'reduction in yield' which may be itemised in any benefit illustration. For example, a regular-premium plan for a 35-year-old male with a death benefit of $200,000 - using a simple balanced fund as the underlying investment - may see a net expected annualised return of 5.37 per cent, from a theoretical 9 per cent gross return over 20 years. This suggests that annual expenses could exceed 3.6 per cent.
ETNs are debt instruments with a market exposure. If you are unfamiliar with them, or are uncomfortable with the credit quality of the issuer, it may be best to refrain from investing in them. It is argued that ETNs may have a place in a portfolio as their tracking error - the extent to which the ETNs deviate from the index - is zero. But ETFs offer low tracking errors as well.
Corporate bonds may be more suitable for investors who want a regular coupon and their principal at maturity, while ETNs are for investors who are willing to undertake the market risks of ETNs to achieve potentially higher returns. And, if you want a pure exposure to an index, you can generally get it through an ETF.
This article was first published in The Business Times.
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