Make the most of limited capital with ETFs

WHEN I was five, I spent my after-kindergarten hours at my grandmother’s place. At about half past five, my uncles and aunts would return from work and interrupt my daily viewing of “Hi-5” to tune in to the Teletext.

The black screen would display lots of numbers and codes, while names such as “Singtel” and “SIA” would get thrown around a lot.

When it was my turn to start investing many years later, all I knew was how to buy individual stocks. That led to a mix of good and bad picks, which have taught me some lessons along the way about how companies and markets work.

Yet, that was probably a lousy way for me to allocate the limited capital that I had. I should have considered investing in exchange-traded funds (ETFs) first.

Managed by fund managers such as SPDR, Vanguard and iShares, some of these ETFs aim to replicate indices such as the local benchmark Straits Times Index (STI) or the S&P 500 Index, a basket of 500 large companies on stock exchanges in the United States.

By buying an ETF that holds shares in a large number of companies, investors can easily create a diversified portfolio. That way, a single company’s performance does not have an outsized impact on returns.

While there are brokerages such as Syfe that allow investors to buy fractional shares, I would guess that no one would individually increase their stakes in 500 stocks every month. Instead, you can simply buy into an index fund that tracks the S&P 500 index and gain exposure to 500 companies at once.

With such a wide range of ETFs to choose from, investors can pick ones that suit their risk appetites and investment goals.

For instance, passive investors who are looking for a strong base to build from may want to consider ETFs that track the FTSE All-World Index or the MSCI World Index, both of which include more than a 1,000 constituents across numerous developed markets.

Both indices returned 34.2 per cent and 40.8 respectively over the last five years ended Jan 31, 2023. Notably, both suffered dips of more than 17 per cent in 2022 as a result of rising inflation rates and the Federal Reserve’s moves to hike inflation rates. Investors should be prepared to ride out some of this volatility as such declines are to be expected during market downturns, especially with equity investments.

Environmentally-minded investors can look at index funds that track the iEdge-OCBC Singapore Low Carbon Select 50 Capped Index, which tracks 50 large Singapore companies with lower carbon footprints.

Those looking to invest in real estate can also consider investing in index funds that track the iEdge S-Reit Leaders Index, which tracks 26 of the largest and most tradable real estate investment trusts (Reits) in Singapore.

After choosing an index, investors should also take note of the size of the index fund. Generally, a fund should have more than US$10 million in assets under management. If a fund is too small, investors may face difficulties selling later. The fund may also be closed if it becomes too small, leading to potential losses if the liquidation of assets is done during a market downturn.

Furthermore, investors should also compare the returns of the index fund with its expense ratio, which is what fund managers earn for managing these funds. Because fund managers usually charge a small fee of 0.1 to 0.3 per cent to manage these funds, investors should note that they will always slightly underperform the index that they hope to track, albeit by a small percentage.

Finally, investors should also take note of tracking errors of the index fund that they are interested in. The lower the tracking error, the closer the fund tracks its index.

For example, the Nikko AM STI ETF has a 3-years annualised tracking error of 0.14 per cent, whereas the SPDR STI ETF has a rolling 1-year tracking error of 0.186 per cent as at Dec 31, 2022.

Personally, I have begun dollar-cost averaging into a FTSE All-World Index fund that is domiciled in Ireland and listed on the London Stock Exchange. The domicile in Ireland reduces the withholding tax on US securities from 30 per cent to 15 per cent and shields me from US estate taxes in future. This is something investors should take note of too.

Aside from passive index funds, there are also funds that are actively managed, such as the ARK Innovation ETF.

While such funds aim to beat the market, they rarely do. The S&P Indices versus Active scorecard found that as at June 30, 2022, 90 per cent of active large-cap funds underperformed the S&P 500 over the last 10 years.

Furthermore, they can have higher expense ratios. For example, the Ark Innovation ETF has an expense ratio of 0.75 per cent. Notably, it has also returned 2.8 per cent over the last five years ended Jan 31, 2023, which is lower than a passive technology index fund such as Vanguard’s Information Technology ETF, which delivered 107.9 per cent in returns over the same period.

Still, that is not to say that active management is a bad idea and it may well pay off for investors to dedicate a small percentage of their investment portfolio to tactical, short-term stock picks.

But first, investors ought to build up a well-diversified stock portfolio before taking greater risks with their investments.