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How well do you understand your ABCDETF?

EXCHANGE traded funds (ETFs) are among the more innovative products to come out of the financial industry in the past two decades.

Basically, ETFs are open-ended index funds that are listed and traded on exchanges like stocks. They allow investors to gain broad exposure to stock markets of various countries, emerging markets, sectors and styles as well as fixed-income and commodity indices with relative ease on a real-time basis and at lower cost than many other forms of investing.

However, before jumping headlong into these ETFs, there are certain ground rules that you must first understand.

Index: ETFs cover many well-known blue-chip indices such as the S&P, FTSE, Hang Seng, Nikkei and SET. But recently, there has been a rise in indices with diverse weighting methodologies, including market capitalisation, equal weight, price, dividend and other fundamental factors.

All these indices have similar-sounding names, but actually they are quite different in risk and reward, so understanding the index is an important step in the selection of an ETF.

Total costs: Expenses erode the return of a fund, so the total expense ratio, not just the management fee, is a major consideration in comparing costs of ETFs. Although ETFs have lower expense ratios than other types of mutual funds, fees will cause an ETF to underperform its index over time.

Trading costs, tracking risk, trading currency, dividend withholding tax and securities lending within the fund should also be considered.

Liquidity: ETFs offer investors two forms of liquidity. The first is through trading the shares on a secondary basis on-exchange. The second is on a primary basis via the unique "creation" process, whereby an "authorised participant" purchases the underlying basket of securities in the local stock market and deposits the basket "in kind" into the ETF, creating more shares in the ETF.

The liquidity of an ETF is driven by the liquidity of its underlying securities, so it is important to note that similar indices can have different liquidity profiles based on their index methodology.

Dividend reinvestment and withholding tax: Some ETFs hold dividends in cash and only pay them out to investors periodically, while some can reinvest dividends daily. A lag in dividend reinvestment can cause small underperformance in rising markets. For non-US investors, dividend withholding tax may be higher when investing in US-listed ETFs as they may suffer dividend withholding tax within the ETFs as well as on dividends paid out of the ETF.

Non-concurrent trading hours: Some ETFs trade when their underlying markets are closed. For example, the Japanese market is closed while an ETF tracking the Japanese is trading on NYSE Arca.

ETFs on broad-based indices can serve as diversified core holdings, while style and sector ETFs can be used for completing parts of a portfolio or for tactical investing. Although most ETFs are passively managed portfolios designed to provide relatively low-cost investment in broad-based or proprietary indices, those investors who would like to adopt a more "active" approach may find a "core satellite" investment strategy appropriate.

Core holdings can help ensure that a portfolio's performance does not deviate widely from established benchmarks, while satellite ETF investments such as sectors, styles, industries, regions or countries constitute active plays in an effort to increase returns.

Nowadays, there is a wide range of ETFs that can serve as the building blocks to gain exposure to underrepresented sectors in a portfolio such as infrastructure, fixed income, commodity, real estate, inverse/leveraged, sector, fundamental, global/regional and single country, and dividend.

As for the Thai market, there are only three ETFs listed on the Stock Exchange of Thailand. These are the ThaiDex SET50 ETF, which tracks the SET50 index; the ThaiDEX FTSE SET Large Cap ETF, which tracks the new big-cap index from the FTSE; and the MTrack Energy ETF, which is a sector ETF.

In terms of size, the SET50 ETF is by far the largest with Bt2.3 billion, while the other two are much smaller at only Bt200 million.

Interestingly, the performances of the ThaiDEX SET 50 and the FTSE Large Cap are very much in line with each other. This is probably because of the similarities of the two indices. The Energy Sector ETF, on the other hand, is an interesting "optional extra" for those investors who want to purely punt the energy sector or add more weight to the sector in their portfolios.

Compared with other actively managed mutual funds, the performance of the SET50 ETF is highly competitive, being ranked 57th out of 177 funds for the one-year period ending May 2010.

As a final point, spend some time looking for the right ETF to complement your portfolio. Make sure to read the prospectus before investing, and it goes without saying that the value of your investment may go up or down. So do check the specific risks, such as political, currency and economic risks, when investing in an ETF exposed to an emerging market, country or region as well as the tax implications. Good luck.

Vira-anong Phutrakul is managing director of retail banking at Citibank.


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