ETFs’ counter-party and collateral risks

By Leong Sze Hian

The Financial Stability Board (FSB) which was set up after the last 2008 financial crisis, and which represents central banks and regulators has said that the increased popularity of synthetic  Exchange-Traded Funds (ETF)s, as well as the more intensive recourse to securities lending by providers of physical ETFs raises new challenges in terms of counter-party and collateral risks.

Singapore ETFs mostly synthetic ETFs

Thus, Singapore investors need to be aware that about 80 per cent of the ETFs in Singapore are synthetic ETFs.
Why ETFs?
The systemic risks not withstanding, let’s take a look at why some investors may prefer using ETFs as their preferred investment vehicle in the first place.
Index investing is better?
Passive index investing is better than using actively managed funds like unit trusts and investment-linked products (ILPs with no insurance) – because most studies have shown that about 80 per cent of index funds tend to out-perform active fund managers.
However, you may also need to be aware that the above generally holds true for the developed markets, and that most studies have found that generally active fund managers tend to out-perform index funds in the emerging markets.
Lower costs?
The cost of investing is lower because the expense ratio of ETFs are much lower than actively managed investment funds.
In the Singapore context, if you try to structure a globally diversified portfolio of about 10 ETFs of about 30% equities, 30% bonds, 20% commodities and 20% property – the expense ratio may likely be around just below one per cent.
So, compared to an investment funds portfolio of typically an expense ratio of say around 1.5 per cent, the expense ratio difference in the Singapore context may not be as large as in other countries.
Also, if you use an investment arrangement whereby you pay say a typical extra one per cent advisory fee per annum – your ETF portfolio’s total expense ratio may become close to 2 per cent.
Structuring  a globally diversified portfolio of equity, bond, commodities and property using ETFs?
… Given the limited range of ETFs in Singapore, are you able to structure a globally diversified a 30 30 20 20 portfolio described above? The answer is not so easy, unless you sacrifice global diversification particularly in the bond and property asset classes.
… The up-front costs of ETFs are much lower than investment funds – as low as about 0.35 per cent trading costs of buying an ETF, similar to buying a stock.
However, to achieve this optimum low entry costs, the investor may need to invest about $100,000 in the 10 ETFs.
The lower your total investment funds available to set up your ETF portfolio, the higher your entry cost may be.
For example, generally a $10,000 investment into 10 investment funds is the minimum amount required to structure a globally diversified portfolio.
However, the entry costs of a $10,000 10 ETFS portfolio may be around 3.5 per cent.
A $20,000 10 ETFs portfolio may be around 1.75 per cent, and so on – up to about $100,000 in order to achieve the optimum lowest entry cost.
The retail layman investor with a small amount to invest?
Compared to say a no front-end load (back-end load for early redemption) investment funds portfolio, the supposedly lower-cost entry of an ETF portfolio may be less evident for smaller investors.
Redemption costs?
Whilst investment funds have typically no redemption costs, the redemption costs of ETFs is the trading cost like selling a stock. So, particularly for long term ETF investors, the redemption cost may be a percentage of your original invested amount which may have increased many times in the future.
Re-balancing costs?
Whilst generally investment funds may have say a free quarterly re-balancing feature, it would incur trading costs for the ETFs portfolio investor if he or she wants to re-balance the portfolio.
The theory behind the desirability of re-balancing may be that the longer a market has gone up and the higher the quantum – the higher may be the historical and statistical probability of a correction relative to the longer and greater a market may have gone down, and vice versa.
Also, particularly for smaller investors, the trading costs of re-balancing may be quite high given that the typical amounts invoked may be quite small.
Practical execution vs theory?
The computation and mechanics of re-balancing may also have to be done manually, unlike free auto re-balancing in an investment funds portfolio – which may be quite a daunting task for the less savvy or sophisticated investor.
In the final analysis, the theory of investing using a globally diversified ETFs portfolio, particularly in the Singapore context, may be somewhat different from its practical execution.