14 things I learned from the Bursa Malaysia ETF Workshop 2019

The Fifth Person was recently invited by Bursa Malaysia to attend an exchange traded fund (ETF) workshop. The workshop — Introduction to ETFs and Portfolio Solutions using ETFs — was delivered by Chong Lee Choo, Director of Innovation Lab & Alternative Investment from Affin Hwang Asset Management.

Just a bit of background, there were 6,478 ETFs listed in 2018 globally. As of 7 September 2018, the U.S. made up about 70% of the US$5.3 trillion global ETF market, followed by the UK and Japan at 7.4% and 5.8% respectively. The value of ETF assets globally are expected to reach US$12 trillion by 2023.

Here are 14 things I learned from the Bursa ETF Workshop 2019:

1. ETFs are similar to unit trust funds where investors pool their funds to invest in a portfolio of assets. These assets can range from bonds (corporate, government, and high yield) to equities (global, single country, and sectoral) and commodities (gold and oil).  Appointed fund managers will invest the funds based on the investment mandate given. All returns earned by the fund after deducting expenses are returned to investors. At the same time, the assets are safeguarded by a trustee.

2. Some of the benefits of investing in an ETF include lower total cost of investment compared to unit trusts. Index ETFs involve mainly passive investing and there is lower portfolio turnover. For instance, reviews of the FTSE Bursa Malaysia KLCI are conducted semi-annually. Therefore, portfolio rebalancing of the FTSE Bursa Malaysia KLCI ETF is only required twice a year and less cost is incurred compared to actively managed unit trusts. Also, it is costly for retail investors to fully replicate an index themselves. ETFs allow investors to gain exposure in an asset class and diversify in a market via a small single transaction. For equity investors, diversification can also be achieved by investing in shares of companies in different industries and operating regions.

3. ETFs generally do not outperform their benchmark index but will track it closely using a full replication strategy, where fund managers invest in all or almost all the constituents of an index. Annual expenses including management fees, trustee fees, and index licensing fees are incurred to operate an ETF. They are often collectively expressed as a ratio over an ETF’s total assets as total expense ratio.

4. Some elements to look out for when selecting an ETF include total expense ratio, tracking difference, and fund size. In an ideal situation, the total expense ratio should not be too high or it’ll eat into investors’ returns. The total expense ratio will also lead to tracking difference, thereby affecting fund managers aiming to replicate an index in full. Also, an index may have too many constituents in too many countries (including foreign currency exchange), thereby contributing to tracking difference. Sometimes, some securities could be illiquid. An ETF with a larger fund size usually means a lower total expense ratio for investors due to economies of scale.

5. Besides a full replication strategy, ETFs can also be partially replicated. In this case, fund managers may choose to invest only in partial of the index constituents and substitute some constituents with other stocks that are highly correlated.

6. Leveraged ETFs magnify the benchmark performance including profits and losses without margin on a daily basis. As a result of the compounding effect and volatility, returns from leveraged ETFs will differ from the benchmark index over the long term.

7. Inverse ETFs provide an inverse performance to the benchmark index on a daily basis. Investors effectively short the market when buying an inverse ETF which will yield positive returns when the market goes down. Theoretically, the risk for inverse ETFs is unlimited as the sky is the limit if the market moves upward against you. Leveraged and inverse ETFs are riskier and more suitable for shorter-term trades.

8. Smart beta ETFs involve both active and passive investing. The ETFs track benchmark indices and at the same time apply specific criteria for index constituents to include stocks in the ETFs using alternatively weighted or factor-based investing strategies. In alternatively weighted strategies, all stocks in an ETF may be equal weighted or tilted based on certain factors like earnings growth. Meanwhile, value, size, momentum, high yield, quality, and minimum volatility are elements considered in factor-based investing strategies.

9. As of July 2019, there are only 11 ETFs in Malaysia that have a total of RM2.1 billion in assets under management (AUM). There are nine equity ETFs, one bond ETF, and one commodity ETF. The bond ETF — ABF Malaysia Bond Index Fund – is currently the largest ETF in Malaysia with an AUM of RM1.5 billion. In Chong’s opinion, an investor can construct a diversified portfolio across different regions and asset classes using the existing ETFs listed on the stock exchange.  

For more details of the ETFs, please refer here.

10. The Securities Commission Malaysia (SC) revised the Guidelines on Exchange-Traded Funds in January 2019 to promote ETF growth and product innovation in the market. 2019 will potentially see 12 additional ETFs listed on Bursa — six of which are leveraged and inverse ETFs, three China thematic, and three factor-based. More potential ETFs will be listed in Malaysia in the future including smart beta ETFs, futures-based ETFs, and synthetic ETFs. The Malaysian government has also shown its support by exempting stamp duty for transactions on ETFs until the end of 2020.

11. Low trading volume of ETFs does not mean illiquidity. Market makers are appointed to provide ETFs liquidity and are sometimes known as liquidity providers. In the primary market, market makers can pay equivalent money in cash or exchange their underlying index shares with ETF units from managers. In the primary market, institutional investors can also create new ETF units. Typically, the amount of the ETF units involved is large. In the secondary market, market makers can offload their units to retail investors when the latter wants to buy at the stock exchange. Alternatively, buyers and sellers can transact with each other through a broker in the secondary market. According to Chong, market makers are always there in the secondary market to transact with retail investors and it is not reflected in the ETF transaction volume. The real liquidity of an ETF is actually dependent on the liquidity of the underlying assets of an index.

12. Chong pointed out that it is beneficial for investors to opt for ETFs over unit trusts in efficient markets like the U.S., where most unit trust (mutual fund) fund managers do not outperform the benchmark index. Unit trusts may be more relevant in emerging markets like Malaysia to derive alpha, the excess return managers can obtain above a benchmark. Also, it is challenging for actively managed unit trusts to consistently outperform in a volatile market. In Chong’s opinion, ETFs and unit trusts will complement each other.

13. Chong shared with participants that index ETFs will stay fully invested most of the time. To avoid underperforming during bull markets, fund managers will ensure more than 97% of their ETF investments mirror the index. The residual amount is maintained in cash to settle expenses like annual management fees.

14. A participant asked Chong how dividends are distributed to ETF investors. Chong explained that fund managers accumulate the dividends received from different companies at different times of the year and pay ETF investors annually. She added that a portion of the dividend is used to settle expenses as well as losses incurred during portfolio rebalancing. As regulated by the SC, dividends can only be paid out from net gains, not unrealised gains. The net gains from dividends will be either reflected in the share price or net asset value of the ETF.