Passive investing has been on the rise in recent years. Among the means of passive investing, the most common method would be index investing where investors replicate and hold investments in broad market indexes or indices. However, manually investing into the various components of the index can be costly, time consuming, and complicated. Thus, investors may turn to Exchange Traded Funds (ETFs) and Exchange Traded Products (ETPs).
Scale of ETFs/ETPs
The popularity of ETFs took off after the GFC of 2008 as investors were looking for cheaper ways to establish diversified portfolios compared to complicated investment products or costly active funds. US-based ETFs ballooned to more than US$4 trillion ($5.5 trillion) in AUM by end 2019 compared to US$770 billion in 2009. Globally, total ETF and ETP assets started the decade with more than US$6.35 trillion before increasing 31.9% in 2019, according to ETFGI’s report. The 10-year ETF/ETP CAGR was at 18.6%.
Investors’ disappointment with high costs and underperformance of active investment managers compared to index performance led to the rise of ETFs as the preferred investment choice. However, the management of the ETF market is also concentrated under a few providers and funds. BlackRock, Vanguard and State Street dominate the US ETF market, jointly contributing to around 80% of market share. The top 10 ETFs in the US market accounts for 28% of total US ETF AUM while the top 20 US ETF accounts for nearly 40%.
What is an index?
There are various indexes, but the most well-known indexes are generally stock market indexes which measure the value of a section of a country’s stock market via a basket of selected stocks. These indexes serve as a basis for market conditions analysis by investors and analysts. Stock market indexes are generally segregated into global, regional, and national indexes. Some examples of indexes would be S&P 500 index, Dow Jones Industrial Average (DJIA), as well as Singapore’s Straits Times Index.
Increasingly, there are also other types of specialised indexes for certain demographics or trends. Examples include indexes focusing on the technology sector such as the recently launched Hang Seng Tech Index, or indexes focusing on factors such as Environmental, Social and corporate Government (ESG).
Calculating an index
Other than knowing the components of the index, it is equally important to know how the index is calculated. The three main types of indexes are price-weighted, value-weighted and unweighted.
Price-weighted indexes are calculated based on the trading prices of the individual components in the index. The higher priced stocks move the index more than those with lower trading prices. One of the most popular price-weighted index is the DJIA. Apple‘s decision to have a 1:4 stock split would result in reduction of its weightage in DJIA from 11% to about 3%, which might be part of the reason for the DJIA recent update in index components.
Value-weighted indexes are more prevalent in stock market indexes. The weight of each component stock in the index would be based on the market capitalisation. S&P 500 index is a prime example of a value-weighted index, where the top five holdings, Apple, Microsoft, Amazon, Alphabet, and Facebook, now total to more than 20% of the index weightage. As the market capitalisation is not affected, Apple’s stock split will not have an impact on S&P 500 unlike DJIA.
Unweighted indexes are equal weighted index, where all components will have the same weightage regardless of price or market capitalisation. Thus, each component will have an equal impact on the index price.
Advantages of index investing
The biggest advantage of index investing is its low-cost nature. The passive nature and lack of costly professional management allow investing into index tracking ETFs to greatly reduce the fees charged. As these ETFs get larger, there is also the benefit of economies of scale. Lower cost translates to higher returns in the long run, assuming a similar fund performance between the average active fund compared to index funds.
Index investing also allows investors to diversify their portfolios Spreading the investment across multiple types of investment can be easily done through investing into indexes which are intrinsically diversified or through a few ETFs.
Another advantage is index investing keeps investors invested, reducing kneejerk reaction due to fear or having selection bias during market movements. After all, consistency is key in investing and index investing makes it easier.
Risk factors
However, index investing does have inherent risks which investors should understand.
Index investing may have to stay invested in underperformers and not take advantage of opportunities in companies showing great potential. As most ETFs track the index passively, underperformers are included in the investment mix until they are removed from the index. Components with strong potential are also restricted by the index weightage.
The lack of professional portfolio management allows lower costs but also increases the risk of slow reaction to market conditions. For example, passive index investing cannot pre-empt the market movement in the case of a foreseen market crisis, thus lacking in terms of downside risk protection.
What’s your risk profile
Though there are some risks in passive index investing, the benefits outweighs the risks and investors can adjust the allocation of passive index investment exposure based on individual risk profile.
Other than traditional passive index-tracking ETFs, there are also growing interest in ETFs tracking other asset classes such as fixed income and alternative investments. There are also more index methodology factors used in new indexes to reduce concentration of exposure in only a select number of component stocks such as in S&P 500.
An example is smart beta ETFs which use alternative rules-based index construction to quantify and eliminate certain factors in the portfolio. In this concentrated ETF market, these smart beta options aim to serve the segment of unmet investors’ needs.
Teo Huan Zi is a branch manager from Phillip Investor Centre (Bukit Batok)
