By TEH HOOI LING
SENIOR CORRESPONDENT

EXCHANGE-traded funds or ETFs are winning over plenty of new fans. These funds, which are traded on stock exchanges just like ordinary equities, try to replicate the performance of a particular market index, which typically consists of a basket of stocks. So buying into an ETF gives an investor 'instant diversification' and exposure to a particular market or segment of the market.

Passive ETFs - just the index stocks without any picking - have annual expenses that range from 0.05 to 1.6 per cent of the fund size. They have the lowest expense ratios among registered investment products.

The fact is, there is no guarantee that the higher fund management fee will get you a higher return. Over the five-year market cycle from mid-year 2005 to mid-year 2009, the S&P 500 Index outperformed 63 per cent of all actively managed large-cap funds. S&P MidCap 400 outperformed 73.5 per cent of mid-cap funds and S&P SmallCap 600 outperformed 67.7 per cent of small-cap funds. It's a similar story for non-US equity funds. Indices outperformed the majority of actively managed funds over the past five years.

Recognising this, more and more funds are moving into the ETF space. According to Barclays Global Investors, the world's largest ETF provider, global ETF assets hit a record US$858 billion at end-July 2009. That's 6.5 per cent above the previous high of US$805 billion in April 2008.

In the first seven months of this year, ETF assets rose 20.6 per cent - beating the 13.5 per cent rise in the MSCI World Index - in US dollar terms.

On the Singapore Exchange, ETFs are among the fastest-growing products - 39 ETFs are listed here, giving investors exposure to Singapore, India, North Asia, Asean, the US, Eastern Europe and Latin America, as well as commodities, including gold. ETF trading volume here surged 75 per cent year-on-year to $3.8 billion for the year ended June 30, 2009. Singapore is now the third-largest ETF market in Asia.

However, some investors may not realise that not all ETFs are created equal.

Different types

There are three common ways to create an ETF. The first - which most people understand an ETF should be - is a fund that buys all the stocks in an index in the same weighting. So the performance of the fund will be exactly the same as that of the index, minus the cost of acquiring the stocks, the fund expense ratio and possibly some friction when there are changes to the index component stocks.

This method can be used for indices with smaller baskets of stocks like, for example, the Straits Times Index (STI), which has only 30 stocks. But there's a problem with indices like Russell 2000, which has 2,000 stocks, or the MSCI World Index.

According to Joseph Ho, managing director and head of ETF sales and marketing for Lyxor in Asia ex-Japan, the first 1,200 companies in the Russell 2000 account for 95 per cent of the performance of the index. The last 800 companies are all very small.

So to do a full replication - that is, to buy all 2,000 stocks in the index - would be very costly. Also, the small companies are not liquid, and it would be very difficult to get hold of the shares. So full replication is not workable.

The way around this is to buy a representative sampling of the stocks in the index. This way, you buy a number of stocks that account for, say, 95 per cent of the performance of the index. This saves the fund some transaction and custodian costs. But the tracking error - the deviation of the fund's performance versus that of the index - will be larger.

Another method is synthetic replication. With this, funds buy synthetic instruments like derivatives that will reflect the performance of an index. Mr Ho says that in the US in the 1990s, an ETF that wanted to do synthetic replication would put $90 out of its $100 in cash. Then, cash yielded 4.5 per cent. The remaining $10 would be used to buy S&P futures contracts. That would roughly give the fund the cash market performance of the S&P 500 Index.

But today, this method does not work any more. Cash yields are close to nothing now. And the performance of the futures market differs from the cash market. So to do synthetic replication, ETF providers these days substitute futures with swaps. And instead of cash, they hold a basket of stocks. Different ETF providers have different structures. So do read up and try to understand the structure of the ETFs you want to put your money in.

Of the 39 ETFs listed in Singapore, more than half are swap-based.

Now, let's look at two ETFs in particular: the Lyxor ETF China Enterprise and db x-trackers FTSE/Xinhua China 25 ETF.

The former holds at least 90 per cent of its assets in a basket of European blue- chip stocks. Up to 10 per cent will be in swaps. The swap agreements are for the Lyxor ETF to exchange the return of its basket of European stocks for the return of the Hang Seng China Enterprises Index (HSCEI). So, theoretically, its performance will almost perfectly match that of the HSCEI - as long as the swap counterparty honours the agreements.

In Lyxor's case, its counterparty is its parent - French group Societe Generale. Mr Ho says Lyxor's method is superior than traditional full replication: 'The method we use, which we pioneered, has very small tracking error. And we don't incur transaction costs to buy the underlying stocks of the index.'

Tracking error and transaction costs eat into the fund performance every day. And the failure of the counterparty occurs only once in a long time. 'Lehman existed 150 years before it failed,' says Mr Ho. 'So investors have to balance the different types of risks and costs. Do you want to endure the daily or monthly costs? Or do you want to take the counterparty risk in return for higher return? The failure of the counterparty may never happen. A risky instrument doesn't result in risky investment.'

But even if the counterparty were to fail, only a maximum of 10 per cent of the fund would be affected. In practice, Mr Ho says Lyxor keeps its swaps exposure at 3-7 per cent of the fund size.

Furthermore, there are also risks for funds that opt for full replication. The fund managers may lend the stockholdings in the fund to other hedge funds to earn extra income. And should one of these hedge funds go bankrupt, the entire fund could be frozen until the courts sort out who gets how much.

Lyxor's model essentially outsources the maintenance of the H-shares portfolio to its counterparty SocGen. In return, it pays the counterparty a fee equivalent to 'x' basis points of the size of the fund.

Mr Ho's claim that Lyxor's method is more cost-efficient seems to be borne out by the fund's performance. Since its inception in October 2006, the Lyxor ETF China Enterprise has outperformed its peers and, surprisingly, even the HSCEI.

According to Bloomberg, in the month to yesterday, the HSCEI advanced 2.83 per cent. The Lyxor ETF, on the other hand, gained 4.7 per cent. Its peers averaged 0.7 per cent.

Year-to-date, the corresponding numbers are 58.5 per cent, 54.7 per cent and 47.04 per cent.

Now contrast the Lyxor ETF with another China ETF, which is operated by Deutsche Bank - the db x-tracker FTSE/Xinhua China 25. According to the prospectus, the fund may:

• Invest in transferable securities and/or use derivative techniques such as index swap agreements negotiated at arm's length with the swap counterparty. The purpose of the over-the-counter (OTC) swap transaction is to exchange the performance of the invested assets against the performance of the index. The investors do not bear any performance or currency risk of the invested assets; and/or
• Invest part or all of the net proceeds of any issue of its shares in one or more OTC swap transactions and exchange the invested proceeds against the performance of the index.

I may have missed it, but there seems to be no mention of any cap on the use of derivatives, except for the caps on exposure to any single counterparty. The annual report, however, shows the transferable securities to be Japanese equities.

So there you have it. Two ETFs which are supposed to give you exposure to China stock indices. But the underlying assets held by the funds are different. And so too are the risk management measures and disclosure level.

As with any investment, make sure you understand what you are getting into before putting your life savings into an ETF. And like all types of investment, diversification is always a good practice.

The writer is a CFA charterholder

This article was first published in The Business Times.