Bean Musing

ETF: An Introduction


With StashAway, a roboadvisor that constructs its portfolios using Exchange Traded Funds (ETF) being the talk of the street for a while now (and of course, questions from my friends asking what ETF is), I figure the product is due for a post.

ETF isn’t exactly a popular product in Malaysia. Unlike trading equities in Bursa, or investing in unit trusts (mutual funds), ETF is investing is relatively unknown.

What is ETF?

As the name says it, it is an investment fund (a pool of money) that is traded on the exchange. Unlike a stock which represents one single company, an ETF holds a basket of underlying securities, which can be equities, bonds, and even commodities.

What is cool about ETF is that it can be constructed in any way - whether to mimic an index, or whether it is to create an active portfolio.

Uhm, what is an index?

An index is a statistical method used to measure change in the securities market. For example, perhaps the most well known is the S&P 500. S&P 500 is made up by 500 large companies in the US, and is often used as a proxy to represent the US market.

To best represent the US market, a weightage is applied to the companies that make up the index. In the case of the S&P 500, the weightage is done via the market capitalization method. If you’re interested in the math, you can take a look at the Index Value Calculation Section.

It sounds a lot like mutual funds! What are the differences?

They are pretty similar in the way that they both represent a basket of securities. However, there are some structural differences. See the table below:

ETFsMutual Funds
Where to buyExchangeFund Manager
PriceMarket PriceClosing Net Asset Value
Management StylePassive / ActivePassive / Active
Expense Ratio (Average)0.23%0.73% passive / 1.45% active

Source for management fee: ETFs vs. mutual funds: cost comparison

One thing I would like to point out is that while 98% of the ETFs out there are passively managed, actively managed ETFs exist. Similarly for mutual funds, while mostly actively managed, there are index mutual funds as well.

Why is the expense ratio higher for mutual fund?

There are a few reasons, but primarily it is due to the structure of the ETF vs that of the mutual funds. You can read more about the mechanism differences in my post: ETF: The Mechanism

How do I know which ETF is good?

There are a few areas to look at:

  • a) Completeness of information
  • b) Expense ratio
  • c) Tracking error

a) Completeness of information

Go through the prospectus. Make sure the prospectus covers the strategy, asset under management, the fund composition, the risks associated, and of course, the return.

b) Expense ratio

In the ideal world, all of us would like to pay zero fees on our investment. While ETFs’ fees aren’t exactly zero, it is as good as it can be. Look at the expense ratio, and compare it against similar ETFs. If two funds are of similar composition, risk profile, tracking the same index, etc, you’re almost always better off going with the one that has the lowest expense ratio.

Sometimes, price isn’t the only thing you look at. The fund’s reputation and size should too, have some bearing on your decision, especially if the difference is small. There is also something called the tracking error. See next point.

There is also the point about underlying liquidity. If the basket of securities held by the ETF is highly illiquid, it will reflect in wide bid/ask spread for the ETF shares.

c) Tracking error

A tracking error measures how closely the fund performance tracks the investment returns of the benchmarks (net of fees). For instance, how does Vanguard 500 Index Fund track that of S&P 500?

You can see the difference is at 0.0x%, which means the ETF is tracking the index well.

Thanks for getting to the end. Do check out ETF: The Mechanism to learn more. I will also be sharing the investing strategies using ETFs in my next post so do stay tuned!