Many ETFs Will Become Easier To Invest In – But Read This First Before You Buy Any

Retail investors may soon be able to gain easier access to a wider range of exchange-traded funds (ETFs) that are currently listed in Singapore.

Earlier today, the Monetary Authority of Singapore had announced a broadening of how Excluded Investment Products (EIPs) are defined. The tweak would likely “see several ETFs converting to EIP status over the course of the next few weeks,” according to Chew Sutuat, Executive Vice President of stock exchange operator Singapore Exchange.

In the past, ETFs which use derivatives – regardless of the purpose or extent of usage – were automatically classified as Specified Investment Products (SIPs).

There’s a lot more hassle involved for retail investors when it comes to investing in SIPs as compared to EIPs. For instance, investors who wanted to invest in SIPs would have to pass through a number of hoops first, including having to undergo tests to determine the level of their investment knowledge.

MAS’s new rules, as mentioned earlier, will likely see a number of ETFs migrate from the SIP-camp into the EIP umbrella. This is great news for retail investors, as that would mean even more easily-accessible investment choices to choose from.

Besides, a wider spread of ETFs would also mean retail investors can diversify their portfolios with greater ease. Hon Cheung, Managing Director of ETF provider State Street Global Advisors was quoted by The Business Times on the topic:

“ETFs are a powerful tool allowing retail and institutional investors to directly access market opportunities from blue chips to other asset classes in a single, cost-effective trade on the exchange.

As ETFs generally hold a basket of stocks tracking an index, for e.g., the STI [Straits Times Index (SGX: ^STI)], investors are able to reduce concentration risk over holding single stocks.”

What Hon said makes sense. But, the statements overlook one very important fact – that holding ETFs need not necessarily reduce the level of concentration risk over holding single stocks.

We can use the SPDR STI ETF (SGX: ES3), an exchange-traded fund tracking the Straits Times Index, as an example.

Based on the ETF’s latest data (as of 28 April 2015), its top-five holdings are, in order of magnitude, DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39), Singapore Telecommunications Limited (SGX: Z74), United Overseas Bank Ltd (SGX: U11), and Jardine Matheson Holdings Limited (SGX: J36).

Weight of various stocks in ETF

Source: SPDR STI ETF’s website; data as of 28 April 2015

The Straits Times Index is made up of 30 shares and you can instantly hold a basket of these 30 stocks through the purchase of the SPDR STI ETF.

But as you can see from the table above, just five of the index’s components collectively account for 50% of the ETF’s weight. What’s more, the banks also have an outsized influence as they make up 33.2% of the entire index.

In other words, though the SPDR STI ETF can allow an investor to hold a diversified basket of names, there is still a very high level of concentration risk involved.

A Fool’s take

The point here is not to ding the SPDR STI ETF as it can still serve a very useful role for many investors – it’s to highlight how ETFs may not be effective in reducing the level of concentration risk even if they do hold a wide variety of stocks.

Before you jump into any ETF, take note that it’s important for you to look beneath the hood so as to gain a better idea of what you’re getting yourself into.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.