Exchange Traded Funds - Simplified

What exactly is an Exchange Traded Fund (ETF)? 

According to Investopedia's definition, an ETF is a security that tracks an index, a commodity or a basket of assets like an index fund but trades like a stock on an exchange.

To simplify:

1. ETFs are basically mutual funds that trade like stocks on an stock exchange.

2. ETF tracks a particular index. There are ETFs that track Singapore or Foreign stock/bond indexes.

3. Unlike mutual funds, which are priced only once at the close of business by the fund company based on the value of the securities owned by the fund, ETFs are priced continuously throughout the day.

Still do not understand? I will use a Singapore Index ETF as an example to explain.

People are more familiar and often see the Straits Times Index (STI) being reported on the news. The STI shows the performance of the Singapore stock market. As I am writing, the STI is up 0.36% and is at approximately 3334 points (see left). The STI comprises the top 30 stocks listed on the Singapore Stock Exchanged (ranked by market capitalization) as shown below:

There are two ETFs that track the STI in the Singapore Stock Exchange - SPDR® STI ETF (ES3) and NIKKO AM Singapore STI ETF (G3B). The SPDR® STI ETF has been listed since April 2002 and the NIKKO AM Singapore STI ETF has been listed since February 2009.

The STI is currently trading at approximately 3,334 points and the respectively ETF is trading at S$3.37 (SPDR® STI ETF - https://sg.finance.yahoo.com/q?s=ES3.SI - dated 27 Aug 2014) and S$3.42 (NIKKO AM Singapore STI ETF - https://sg.finance.yahoo.com/q?s=G3B.SI&ql=0 - dated 27 Aug 2014). 

SPDR® STI ETF and NIKKO AM Singapore STI ETF are Designed to Mimic the STI

These mentioned ETFs are designed to mimic the STI. If the STI has a bull run and rises to 4,000 points, both mentioned ETFs will be traded at approximately S$4.00. Likewise, if the STI has a bad run and drops to 2,000 points, both mentioned ETFs will be traded at approximately S$2.00.

Why the discrepancy in price between the mentioned ETFs?

In all ETFs, there is always a tracking error. A tracking error tells us how much an ETF would deviate from the index's performance. A high tracking error may result in an erosion of index's gain by the ETF.

Owning an STI ETF is like owning 30 Different Stocks

By owning units of an ETF that tracks the STI, you are basically owning 30 different stocks as mentioned above. On top of getting the diversification, you are able to purchase as little as one lot to gain exposure to the Singapore market. You gain the same exposure without having to spend more money buying the component stock of the STI. Can you imagine owning just one lot of every stock in the STI? S$17,950 for just one lot of DBS shares. 

But with ETFs... 

The two ETFs have different board sizes - 1,000 shares for SPDR® STI ETF and 100 shares for NIKKO AM Singapore STI ETF. At the current price of S$3.37, the minimum investment in SPDR® STI ETF will be S$3,370. At the current price of S$3.42, the minimum investment in the NIKKO AM Singapore STI ETF will be S$342. Both the minimum investment excludes the broker commission and transaction fee.

To Summarize...

1. There are various ETFs - different types of ETF that tracks Stock or Bond or Commodity Index. 

2. ETF's objective is to mimic a specific Index.

3. ETFs are traded on a stock exchange, you can buy and sell units of ETFs throughout the trading day.