SGX: Global growth and the broad-based, cash-based ETFs

This week the International Monetary Fund (IMF) released its latest World Economic Outlook which shaved growth projections across the globe for 2011 and 2012 on the key thematic of slowing growth and rising risks.

Global Growth Revisions

In vogue with the recent Monetary Authority of Singapore’s economic outlook, the pressure of the external environment versus regional resilience was reflected across the IMF’s revision of GDP growth rates in 2011/12. The IMF’s category of ASEAN-5 (comprised by the economies of Indonesia, Malaysia, Philippines, Thailand and Vietnam) is among the least affected regions by almost blanket cuts to expected GDP growth rates across the globe in 2011/12. The ASEAN-5 is expected to grow by 5.3% in 2011 (from 5.4%) and 5.6% in 2012 (from 5.7%).

Elsewhere in Developing Asia, China is expected to grow by 9.5% in 2011 (from 9.6%) and 9.0% in 2012 (from 9.5%), attributed to policy tightening and moderating net external demand. India, led by private consumption, is expected to grow by 7.8% in 2011 (from 9.6%) and 9.0% in 2012 (from 9.5%). Growth for Developing Asia as a whole was reduced to 8.2% in 2011 (from 8.4%) and 8.0% (from 8.4%) in 2012.

This contrasts to the GDP growth rates of Europe and United States. The Euro Area is now expected to grow by 1.6% in 2011 (from 2.0%) and 1.1% in 2012 (from 1.7%) while the United States expected to grow by 1.5% in 2011 (from 2.5%) and 1.8% in 2012 (from 2.7%). The United States was the most impacted economy by these downward revisions.

GDP growth represents a gauge on the expansion in market value of products and services delivered by a country or region. As a whole, World Growth is now expected to grow by 4.0% in 2011 and 2012. Singapore is expected to outperform the global rate at 5.3% in 2011 and 4.3% in 2012. Pertaining to the regional resilience, the IMF purported that ASEAN-5 growth while affected by external demand, will be supported by domestic demand, “in particular, robust investment—which will offset the slowdown in export momentum”. The IMF also noted that “while commodity prices will remain supportive, they will provide less of a boost to growth for the commodity exporters (Indonesia, Malaysia)”.

Overall, in terms of the overhang of the external environment, versus the support of resilient regional demand, the IMF were clear that the risks of the former outweigh the latter. The World Economic Outlook noted the “upside risks from continued support from accommodative policies are more than offset by a potentially larger drag from external demand, potential pressure on commodity prices, and persistent financial shocks from the euro area and the United States that threaten to eventually impinge on domestic demand and regional financial stability”.

This IMF’s message was also conveyed in the MAS Report on Recent Economic Developments in Singapore that stated Singapore’s “external performance in the second half of the year will be capped by external these developments”, however “resilient Asian demand should partially offset these headwinds from the industrialised countries in the next two quarters”.

Broad-based Macroeconomic Investment Mediums

The question of whether outperforming macroeconomic returns provide investable economics depends on the amount of market premium that is placed on this macroeconomic potential. Equity Indices are comprised of listed corporations otherwise referred to as constituents, that are priced according to fundamentals, such as earnings, cash flows, dividends, assets and market outlook.

The key caveat for regional investors is that just because an economy is growing at 10% does not imply its benchmark equity indices will rise by 10%. The case in point is the China economy which grew at 9.2% in 2009 and 10.3% in 2010, with the FTSE China A50 Index inclining 83.7% and declining 23.5% in the respective years.
Index pricing will be a function of the aforementioned fundamentals in addition to market expectations of future performance and investor appetite to participate in the index. An element of the price performance of MSCI Indonesia, MSCI Taiwan and MSCI Malaysia Indices in 2010 could be attributed to the ASEAN-5 domestic demand come regional resilience potential. In 2010, the MSCI Indonesia Index rose 23% , MSCI Thailand rose 37% and MSCI Malaysia rose 19%. With the resilience theme built into the index pricing into 2010, the 2011 year-to-date performance has been more subdued for the three Indices, with MSCI Indonesia flat, MSCI Thailand down 4% and MSCI Malaysia down 9%.
Investing on macroeconomic performance requires diligence, education and risk management techniques that take into account the risk appetite and objectives of the investor. An understanding of what economic principles and outlook is priced in and what is not priced is obviously important for those traders that might not be utilizing timing techniques such as technical analysis. Indicators that are associated with GDP that surprise investors on the upside or downside have the potential to change the macroeconomic premium associated with the benchmark index.
Securities Investors Association (Singapore) currently offer investors a series of courses on interpreting annual reports for stock selection. The interpretation of annual reports represent the initial building blocks of the fundamental approach to equity index trading and investors can express their interest here.

Cash-based ETFs

Singapore Exchange (SGX) provide investors with a number of products that are based on broad based index benchmarks, including 13 cash-based Exchange Traded Funds (ETFs) that employ either full replication or representative sample methodologies. The cash-based ETFs that are listed on SGX have discretion as to whether they mange the ETF assets using the full replication or representative sampling methodology.

A fully replicated ETF holds the same stocks in the same proportion as the weights of the constituent stocks in the benchmark index. An ETF that is constructed using representative sampling holds a selected number of constituents stocks of the underlying index according to their degree of historical correlation with such index. That is the ETF holds a sample of constituent securities that statistically represents the index.

The full or partial replication methods imply that underlying assets will only be comprised of securities and cash, not derivatives such as futures, p-notes and swaps.

The most liquid of the SGX cash-based ETFs are tabled below.

Counterparty risk on the cash based ETFs is reduced as investing activity is in the actual basket of constituent stocks that the ETF is tracking against the benchmark index. For example, the assets of the DBS Singapore STI ETF consists mainly the constituent stocks of the Straits Times Index. Cash based ETFs can however be associated with higher tracking errors, mainly due to the drag from expenses and tax withholdings on dividend payments that also depends on the complexity of benchmark index and the accessibility of the underlying market.

The key risks involved with cash ETF investing involve tracking error risk, market risk, foreign exchange risk and counterparty risk arising from stock lending activities. On the latter point, as some ETFs may engage in stock lending activities to increase its returns, there is a risk that the ETF manager may not be able to recall the loaned stocks from the borrower.

The full list of ETFs offered by the SGX and its structure classification, i.e. cash or synthetic swap or synthetic derivative embedded is available on the SGX website.

Investors, whether seeking long or short market exposure through ETFs are encouraged to seek education before implementing the investment decision.

FTSE ASEAN 40 ETF & S&P 500 ETF

The SGX FTSE ASEAN 40 ETF was established as an ASEAN government initiative to position ASEAN as an asset class. This fund is designed to track the FTSE ASEAN 40 Index, which comprises the forty top stocks by market capitalisation and adjusted for free-float across Indonesia, Malaysia, Philippines, Singapore and Thailand.

The FTSE ASEAN 40 Index rose 24.5% in 2010 and has declined 7.5% in 2011 as of the 22 September open. The ETF is managed by CIMB Principal Asset Management Berhad. The fund advisor Barclays Global Investors and the market maker is Citigroup.

The SGX iShares S&P 500 Index ETF objective is to seek investment results that correspond generally to the price and yield performance, before fees and expenses, of large-cap stocks in the United States, as represented by the Standard & Poor’s 500® Index. The iShares S&P 500 Index ETF rose 12.8% in 2010 and has declined 7.2% in 2011 as of the 21 September close.

Over the month of August, SGX turnover reached a record of over S$1.1 billion in Aug. The SPDR® Gold Shares in the table above was the main highlight accounting for 40% of SGX ETF turnover given the recent global macroeconomic focus.

ETF Strategies

Two popular investor strategies that involve cash-based ETF strategies are cash equitisation and the core-satellite portfolio strategy.

In a core-satellite portfolio strategy, the core investment is often comprised of board based index products while satellite investment are normally represented by more concentrated investments that riskier and are expected to provide higher returns. Investors can build a core market portfolio with ETFs and add stock picks (satellite) for additional out-performance. In this way, passive funds can be part of an active strategy.

Cash equitisation strategies are short term strategies that involves using ETFs to quickly convert cash returns into equity returns, thereby obtaining, or possibly maintaining a form of equity market exposure. An example of cash equitisation is provided on the Blackrock iShares^® website that states “financial professionals can use ETF investing short-term in the market while refining a longer-term investment view or deciding from which active manager or separate managed account to choose.”