What you buy may not be what you get

Analysts deciding on changes in the composition of stock indexes wield enormous power.

They operate in a world increasingly driven by investors pouring copious amounts of cash into passive investments such as exchange-traded funds (ETFs).

ETFs are instruments that are traded like shares in the stock market, but which track market indexes such as the Straits Times Index (STI).

They are becoming very popular among investors because of their low management fees which can be as low as 0.3 per cent of the value of assets they manage.

All this means the opinions of these analysts, as they tweak indexes, carry more weight than what the creators of the indexes might originally have imagined.

Take the S&P 500 Index. Decisions made on any changes to the widely watched Wall Street index have a powerful bearing on the staggering US$2 trillion (S$2.5 trillion) worth of funds that track it.

The big worry is that the widely used benchmarks used by fund managers no longer measure what they set out to measure.

There is also a concern that those familiar with the index pickers' methodology may try to dress up a counter in the hope that it can join a key market index. Once that purpose is achieved, this obliges pension and exchange-traded funds tracking that particular index to buy their shares.

But since these are passive investors, it is an act of blind faith on their part to rely on the opinion of the index provider to offer the list of stocks to invest in a particular sector or market.

Worse, the heavy emphasis on market indexes means that even fund managers, who are supposed to be actively managing money in their care, may follow suit.

This is because their performance is judged by comparison to the benchmark index.

So if a particular stock in the index is a high-flier, they would have underperformed the index if they fail to gain exposure to it as well. That would, in turn, affect the fees payable to them.

So it is not surprising for companies to display proudly on their promotional literature any membership of widely followed indexes compiled by index providers such as MSCI and FTSE.

But this practice means that as every fund manager and his dog starts to chase after a hot stock in the index, a huge investment bubble may form, inevitably ending in grief when it finally bursts.

One good example is LionGold Corp, which flagged its inclusion in the MSCI Small Cap Global and Singapore Indexes this year.

Dealers suggest this could be one reason which panicked some fund managers into buying the stock, as it commenced its rocket-like ascent earlier this year. In other words, they feared they might be punished for underperformance if they did not buy in.

But it turned out to be their undoing as well, as the stock has collapsed by 90 per cent in value since last month.

Bloomberg data shows that New York-based asset manager Van Eck Associates owns about 6 per cent of LionGold as part of an ETF it manages, which aims to give investors exposure to small and mid-cap gold mining plays.

Another big investor is Australia-based Macquarie Group, with about 4.78 per cent of LionGold.

As LionGold's market value evaporated by $1.3 billion in the past two months, the value of Van Eck's holdings tumbled by about $78 million while Macquarie's fell by $62 million over the same period. This resulted in a total loss of $140 million for their investors. These are not trifling sums.

Even for widely followed indexes such as the STI and Hong Kong's Hang Seng, there is the issue that many component counters in their basket of stocks derive the bulk of their revenues from overseas.

So, if an investor buys into an ETF tracking, say, the STI in the belief that he is getting exposure only to the Singapore economy, he would be sadly mistaken.

Retired stockbroker Narayana Narayana said: "As many as five of the STI component stocks are Hong Kong-based and one is Thai. Four are quoted in the volatile US currency."

In other words, if an investor buys into an ETF tracking a particular sector or region, he should not kid himself that this gives him exposure solely - or even mainly - to those places.

But if he picks an ETF whose stocks are listed in Singapore, he can at least be assured of the high standards of rules and corporate governance which guide listed firms here.

Still, while ETFs provide the assurance of diversification, an investor may still nurse some painful losses, if some high-flying constituent counter crashes. So, take care even in investing in ETFs. Choose the indexes which they track carefully.

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