EQUITIES 6 minutes to read

Why ETFs are useful in volatile times?

Jane Fu

Singapore Sales Trader

Summary:  Many market participants are currently of the opinion that huge volatility lies ahead. Investors are urged to “find a parachute”. With this in mind, ETFs should be viewed as essential tools that investors can use to help deal with the risks that await.


It has been quite a challenging year for investors across various asset classes. The S&P 500 and Dow Jones indices are now trading only a little above this year’s starting levels. More than 200 S&P500 component stocks have fallen into  technical correction – by definition, when a stock price falls more than 20% from its peak, then it is considered to be entering into “technical bear” area. At the same time, yield spreads continue to put considerable pressure on bond traders. No matter whether you are an optimist or a pessimist, one common view shared among all market participants at the current juncture is there will be huge volatility ahead. In Saxo’s Q4 2018 Outlook, our Head of Equity Strategy, Peter Garnry, urged our clients to “find a parachute” as impact is close.

Exchange Traded Funds, best known by their acronym ETF, are securities that track performance of an individual underlying product (or a basket of same) including. but not limited to commodities, bonds, a sector of stocks or an index. ETFs are attractive because of their liquidity, usually low costs and exchange-traded nature. ETFs combine the features of mutual funds and close-ended funds but can be bought and sold throughout the trading day at their net asset value. Across markets, ETFs allow investors to invest globally without the hassle of picking individual stocks or bonds from each country and are therefore a cost-effective and efficient choice.

StockETFMutual Fund
Trade on exchangeYesYesNo
Intraday pricingYesYesNo
Management styleNAUsually passiveUsually active
Management FeeNAUsually low (below 1%)Usually high (1-3%)
DiversificationNoYesYes

ETFs have been available in the US since 1992 and in Europe since 1999. By now, ETFs form a $5 trillion industry with an annual growth rate of about 18%. In the US market alone, there are more than one hundred ETF issuers with the handful holding a majority of the market share. BlackRock’s iShare accounted for about 35% of the market share with assets under management (AUM) of more than $1.75 trillion, followed by Vanguard, State Street and Charles Schwab as a fast-growing new entrant.

Investors could utilise ETFs for different investment and trading needs.

Asset class allocation

For long-term investors, you can choose an ETFs that track certain asset classes, an equity index or certain sector to increase exposure to them. For example, an equity investor could buy a bond ETF to have fixed-income exposure. Traditionally, minimum entry requirement for bonds and commodities trading are rather high, retail investors may not have the channels to invest in these asset classes, with ETFs, a new door opens. As ETFs can be traded as conveniently as stocks, investors can easily rebalance their portfolios without buying and selling individual products. Depending on different investment objectives and risk profiles, there are many ETFs to choose from that meet investors’ wealth management needs.

Before selecting an ETF, investor have to have a view as to which asset class or sector they wish to be exposed to. Then they can pull out information on an ETF’s holding and weightage to see if that matches their expectation. If so, it is highly likely the ETF will be the ideal choice.

Hedge Stock Exposure

Investors who already hold some individual stocks can use index ETFs or inverse index ETFs to hedge downside market risk. For example, if a client holds some blue-chip component stocks in the Hang Seng index he can trade an Inverse Hang Seng Index ETF. Effectively, any loss in his stocks should be offset by gains in the ETF position.

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Source: Bloomberg (Reverse Relationship of HIS inverse ETF and HIS heavy weighted stocks: Tencent & Ping An)

Speculative Trading

A third reason for trading ETFs is simply to exercise a view on the market and trade short-term price movement. Currently, bond ETFs, index ETFs and commodities ETFs are very popular vehicles. Traders could easily buy and take profit within a day or a few days.

Thematic Investment

Traditional ETFs are passively managed and commonly track an index or a fixed list of instruments. Most recently, many ETF issuers have come up with customised thematic ETF and actively manage the holdings and weightage. This type of thematic ETF works similarly to mutual funds but maintains low cost. In 2017, thematic ETFs around driverless car, AI, blockchain and O2O concepts have gained traction and the performance beat the overall market.

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Source: Bloomberg (1-year performance over some AI, block chain, O2O themed ETFs)

To make wise choice among similar ETFs, investors have to look at a few important indicators.

1) Premium/Discount from its Net Asset Value

Usually an ETF tracking the same underlying products could be listed on more than one exchange and different issuers may also offer similar ETF tracking the same underlying asset. When buying an ETF, the most important factor to consider is the premium/discount rate from its Net Asset Value (NAV) given the same liquidity and volume.

The formula to calculate premium is as follows:

ETF premium (discount) rate = (ETF price - ETF net asset value) / ETF asset net value %

If the premium is positive, it means the current price is higher than its net asset value; when the premium (discount) is negative, it means the ETF is traded lower than its net asset value. In theory, investors should pick an ETF that is trading at discount as good bargain because usually premium or discount to net asset value is caused by short-term fearful sentiment in the market and will eventually be normalised and bring the price back to its net asset value level.

2) Net fund flow

Positive net inflow to funds shows buyers are actively entering into the market and net outflow means bearish sentiment prevails. The formula to calculate is:

Net Fund Flow= Change in outstanding share x Average traded price

This information could be easily retrieved from public website like www.etf.com or from the fund’ s website.

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Source: Bloomberg (Emerging market ETF YTD flow)

As much as we think ETFs are highly efficient tools they are not risk free. Like all other financial products they are subject to market risk, counterparty risk and liquidity risk just to name a few. Investors need to do their homework before committing to ETF trading.

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