Benefits of exchange traded funds (ETFs)

During the sharp continuous decline of the bear market in year 2008 until March 2009, I learnt about the importance of "waiting patiently for the perfect pitch to buy stocks", "averaging down only when prices are significantly undervalued after waiting for the dust of the bear market to settle" and "focused investing in selecting only a few excellent companies to concentrate one's investment". It was also then that I discovered a new investment product that is superior to unit trust funds that I have so far invested with insurance companies.

Prior to the bear market of 2008, I had no knowledge of stocks investment. I had invested my CPF funds into a few different unit trust funds since 2006. All my unit trust funds had performed well during the run in 2007 just before the sub-prime crisis came. When the sub-prime crisis came, as with the global stocks markets, all my unit trust funds also decreased sharply in value until I saw paper losses for every unit trust funds I had.

It was then that I reflected carefully on the worthiness of investing in unit trust funds. All the myth about steady growth in returns on unit trust funds described by my financial consultants suddenly seemed so distant in reality. I wondered why my CPF funds have instead depreciated over the four years since I had started investing in unit trust funds. Of course, one can argue that during the financial crisis in 2008, most investment products were not spared, much less unit trust funds. It was also during year 2008 that I was introduced to a superior investment product (exchange traded funds - ETFs) that provides similar features as unit trust funds by my brother who was a more experienced stocks investor who had entered the stocks market much earlier than me.

Exchange traded funds (ETFs) are similar to unit trust funds in that both are diversified investment products. ETFs and unit trust funds usually invest in a basketful of securities based on either geographical locations, individual sectors, diversified sectors or individual assest classes. For example, the Straits Times Index Exchange Traded Fund (STI ETF) invest in the 30 component stocks in Singapore (restricted to the location of Singapore). Gold ETFs invest in the assest class of gold. REIT ETFs invest in a number of real estate investment trusts as another assest class.  Many ETFs have came into the investment scene in recent years. This provides investors looking at diversification into particular regions, assest classes or sectors a chance to invest in the many innovative ETFs that have been created so far.

Apart from offering diversification, ETFs also boast of minimal annual charges compared to higher annual charges incurred by investing in unit trust funds. Annual charges though small still eats into the returns from investing in either ETFs or unit trust funds. Thus, it is better to have minimal charges incurred by investing in ETFs than unit trust funds. However, if one trades an ETF frequently through online brokerages, the transaction costs added in may not make ETFs more attractive than investing in unit trust funds since the total charges and transaction costs of trades made may even be higher in investing in ETFs than unit trust funds.

ETFs provide liquidity since ETFs units can be easily bought and sold through online brokerages. An investor can buy and sell ETFs units at exact quoted prices through online brokerages. However, it is a longer process to buy and sell units of unit trust funds. An investor looking to buy or sell units of unit trust funds may not get the exact price he wants due to delay in time needed to settle the transaction of the units and the investor may buy or sell at delayed prices reflected few days later.

Some ETFs may provide dividends for investors that unit trust funds may not provide. As such, an investor has a steady income stream through dividends given by ETFs even while invested which unit trust funds may not offer. Dividends can be used for reinvestment to allow compounding to work for the investor.

After considering the benefits of ETFs over unit trust funds, I decided to divest all my CPF funds from unit trust funds and started buying up units of STI ETF from early 2009. I recalled a friend of mine who also researched into investments told me that he will not invest in shares of companies for fear of company failures, even that of large companies. Though I am not so extreme in thinking as him, I still cannot help but agree that no matter how excellent a company is perceived to be, there is always the possibility of failure as nothing is perfect in this world. As such, I make it a point to invest in STI ETF which invests in 30 component stocks of STI. This is a conservative approach to protect one's capital from potential loss since we cannot have all 30 companies fail at the same time. The probability of that happening is just too low.

I managed to have an average holding price of around $1.73 per unit of STI ETF after buying into the units over a period of few months. Considering now that Straits Times Index (STI) has increased from its low of around 1500 points in March 2009 to current close to 2700 points, I was fortunate to invest near the bottom. By investing most of my CPF funds heavily into STI ETF during early 2009 when STI was at the low range, I was being "greedy when others are fearful", and also "swinging the bat when a perfect pitch has arrived".

Another point to note is that since only 35% of CPF funds from ordinary account can be only invested into stocks, one can use the other remaining 65% of the ordinary CPF funds to invest in professional investment products (of which the only one that is eligible under this category is STI ETF). This makes sure that all CPF funds from ordinary account can be invested in stocks and STI ETF getting a potentially higher annual rate of return than 3.5% (given by CPF if one leaves the CPF funds idle in the ordinary account). Of course, over here we are also assuming the CPF funds allowed for investment is on top of the first $20,000 in the CPF ordinary account that cannot be invested.

Discussion points:-
ETFs offer similar features to unit trust funds but at a lower annual charge.
ETFs also offer dividends which many unit trust funds do not.
ETFs can be easily traded over online brokerages with better transparency in prices than unit trust funds which take much longer to transact the units.

One can invest the remaining 65% of CPF funds in ordinary account into STI ETF apart from the 35% cap allowed for stocks. All investible amounts is on top of the first $20,000 in the CPF ordinary account which cannot be invested in any form. It maybe better to invest one's CPF funds prudently into an investment product (STI ETF) that offers diversification and potentially higher annual rate of returns than 3.5% given by CPF ordinary account on funds that remains in the account.

If an investor is knowledgeable and prudent, it is afterall better to use the CPF funds to do own investment getting potentially better annual rates of return than leaving it untouched in the CPF ordinary account.