How ETFs work?
by ETFZone staff
ETFs are securities certificates that state legal right of ownership over part of a basket of individual stock certificates. Several different kinds of financial firms are needed for ETFs to come into being, trade at prices that closely match their underlying assets, and unwind when investors no longer want them. Laying all the groundwork is the fund manager. This is the main backer behind any ETF, and they must submit a detailed plan for how the ETF will operate to be given permission by the SEC to proceed.
In theory all that a fund manager needs to do is establish clear procedures and describe precisely the composition of the ETF (which changes infrequently) to the other firms involved in ETF creation and redemption. In practice, however, only the very biggest institutional money management firms with experience in indexing tend to play this role, such as The Vanguard Group and Barclays Global Investors. They direct pension funds with enormous baskets of stocks in markets all over the world to loan stocks necessary for the creation process. They also create demand by lining up customers, either institutional or retail, to buy a newly introduced ETF.
The creation of an ETF officially begins with an authorized participant, also referred to as a market maker or specialist. Highly scrutinized for their integrity and operational competence, these middlemen assemble the appropriate basket of stocks and send them to a specially designated custodial bank for safekeeping. These baskets are normally quite large, sufficient to purchase 10,000 to 50,000 shares of the ETF in question. The custodial bank doublechecks that the basket represents the requested ETF and forwards the ETF shares on to the authorized participant. This is a so-called in-kind trade of essentially equivalent items that does not trigger capital gains for investors.
The custodial bank holds the basket of stocks in the fund’s account for the fund manager to monitor. There isn’t too much activity in these accounts, but some cash comes into them for dividends and there are a variety of oversight tasks to perform. Some managers have leeway to use derivatives to track an index.
This flow of individual stocks and ETF certificates goes through the Depository Trust Clearing Corp., the same US government agency that records individual stock sales and keeps the official record of these transactions. It records ETF transfer of title just like any stock. It provides an extra layer of assurance against fraud.
Once the authorized participant obtains the ETF from the custodial bank, it is free to sell it into the open market. From then on ETF shares are sold and resold freely among investors on the open market.
Redemption is simply the reverse. An authorized participant buys a large block of ETFs on the open market and sends it to the custodial bank and in return receives back an equivalent basket of individual stocks which are then sold on the open market or typically returned to their loanees.
What motivates each player? The fund manager takes a small portion of the fund’s annual assets as their fee, clearly stated in the prospectus available to all investors. The investors who loan stocks to make up a basket make a small interest fee for the favor. The custodial bank makes a small portion of assets likewise, usually paid for by the fund manager out of management fees. The authorized participant is primarily driven by profits from the difference in price between the basket of stocks and the ETF and on part of the bid-ask spread of the ETF itself. Whenever there is an opportunity to earn a little by buying one and selling the other, the authorized participant will jump in.
The process might seem cumbersome but it does allow for transparency and liquidity at modest cost. Everyone can see what goes into an ETF, investor fees are clearly laid out, investors can be confident that they can exit at any time, and even the authorized participant’s fees are guaranteed to be modest. If one allows ETF prices to deviate from the underlying net asset value of the component stocks, another can step in and take profit on the difference, so their competition tends to keep ETF prices very close to it underlying Net Asset Value (value of component stocks).
Counting on the nest egg
By SHAHANAAZ HABIB
With people living longer, marrying and having children later and not saving enough, facing retirement is a challenge. While there is growing awareness about the need to plan, less than 5% are prepared for retirement and fail to take into consideration inflation rates and rising medical costs.
IN 1981, when Azman graduated, he got a job in KL which paid him RM1,800 a month. He bought an imported Mazda at RM17,000 and months later he put down money on a RM78,000 single-storey terrace house.
Today, 25 years later, Azman’s daughter has just finished university. Her starting pay is RM1,800, just like her father’s two and a half decades ago.
Long road ahead: With the life expectancy of men at 72 and women at 76, most people have a good 20 years to live after retirement.
But unlike her father’s time, imported cars cost over RM100,000 today. So Latifah has opted to buy a Proton for RM45,000 (more than double what her dad paid for his first car).
While her father could afford to buy a house early in his career, Latifah can’t. Houses in KL these days cost at least RM200,000, so she has to work for a few years first before she can own one.
Compared to 25 years ago, the prices of goods, food, petrol and electricity have all gone up. Understandably, it’s an uphill task for Latifah to save on her RM1,800 salary, since the purchasing power of her salary is much lower than her father’s back in the 1980s.
It is a fact that wages have not moved in tandem with the rise of the cost of living and inflation. That trend is expected to continue.
And if people do not start planning early for their retirement, they are going to find themselves in a spot after they turn 55.
Today, three meals cost you RM20 but in 20 years time – with an inflation rate of 6% a year – you will need RM64 per day for the three meals, estimates financial consultant Hazel Ong Archibald of CIMB Wealth Advisors (see Chart 1). The government puts inflation rate at 3.2% to 4.8% but Ong says in urban areas, that figure is about 6%.
So while the RM500,000 in your EPF or bank account at retirement might look good on paper, she says, if you do not invest that money to make it grow at a rate higher than the inflation rate, 20 years later, it would be worth only RM145,053 in purchasing power!
While there is more awareness about retirement planning these days, particularly in the urban areas, in reality this does not often translate into preparedness.
Why?
“Because it is more pleasurable to spend than to save,†opines Ong.
People understand – at head level – the need to plan and save, she says, but at heart level, emotions rule and instant gratification wins the battle.
“I wanted to persuade a friend to save for the future but she kept saying she had no money but then later I saw she could sign up RM3,000 and RM5,000 for some slimming packages!â€
Reality hits when people find that they cannot afford to retire because they had not seriously put aside the money early on in life.
Ng: ‘Less than 5% are prepared for retirement’
“Less than 5% are prepared for retirement,†estimates Life Insurance Association of Malaysia (LIAM) president Ng Lian Lau.
He says those in their 20s think they are too young to think about retirement, while those in their 30s and 40s tend to believe they are doing enough because they have their EPF savings, and those who are 55 feel it is just too late for them.
And the truth is at 55, most people cannot afford to retire.
“People are living longer, life expectancy for women is 76 years. For men it’s 72. With this kind of longevity, people have got more than 20 years after retirement. 60 would be a more ideal retirement age,†he says.
People are marrying later too, points out Ong.
Which means they are having children later in life. If a person has a kid at the age of 35 and retires at 55, the odds are that his child at 20 would probably still be at university or college and his education require financing.
On average, the Malaysian household spent 5.7% on education last year. With the cost of education rising by 6% each year, this is expected to climb steadily.
While parents might buy an education insurance plan for their children, Ong has found that 90% of the time the amount is insufficient. More often than not, parents are willing to give up “everythingâ€, including their own retirement fund for the kids. Which leaves them in a vulnerable position in their old age, unless of course their children provide for them.
As for life insurance, only 40% of Malaysians are covered. Ng says this is a small number compared to 100% in Singapore, 80% in the United States and 400% in Japan (where one person has four policies on average).
Ong: ‘Inflation rate in urban areas is 6%’
And even if one has a life policy as well as savings from the EPF, people should still worry about retirement. This is because without a new source of income, that money would run out. This is especially so if one runs into health problems which is common when people grow older.
“Medical inflation is easily 15% each year. And this could really eat into the savings,†warns Prudential Assurance Malaysia Bhd CEO Tan Kar Hor.
Tan likens the medical bill as a “hole†which if not plugged would leak away one’s entire retirement and savings.
“It’s only a question of how the big the hole is,†he says.
So parliamentary secretary to the Finance Ministry Datuk Seri Dr Hilmi Yahaya’s announcement on Thursday that amendments to the Employees Provident Fund Act would allow contributors to withdraw money to buy insurance for critical illness for themselves and their family is welcome news. The amendment Bill was passed in Dewan Negara that same day.
So how much would one need for retirement?
Experts say this depends on the individual and his lifestyle. And how much he is willing to reduce consumption – to eat out less often, buy fewer things, live in a smaller house, drive less, drive a smaller car and travel less.
The rule of the thumb, says Ng, is managing on 60% of your last drawn pay.
For Ong, it’s 70% of one’s current lifestyle. If a family in Kuala Lumpur with two kids and two cars needs RM5,000 today, at retirement, expenses should go down to RM3,500.
Even based on this calculation, one would need RM747,000 if one were to live for 25 years after retirement, and RM806,200 for the next 30 years, factoring in the inflation and interest rates.
Going by statistics revealed in EPF’s 2005 annual report, about 90% of EPF contributors have less than RM100,000 in their accounts. So sole dependence on one’s EPF savings as a safety net is not good enough.
Assuming that one can live on RM1,000 a month, to survive for 25 years, one would still need a substantial RM300,000 and for 35 years, RM420,000.
Bank Negara’s Counselling and Debt Management Agency (AKPK) CEO Mohamed Akwal Sultan reckons a person should not start purchasing big assets like property or a house late in life as the danger is that once they have retired they may not be able to meet the instalment payment on it.
“When you are in your late 40s, you should be winding down and not committing to high expenses to buy big things,†he says.
AKPK has dealt with a number of cases where retirees have had banks auction off their houses because they could not meet the monthly loan payment.
There is also the problem of credit card temptation. Ng notes a worrying trend that more and more younger people are becoming bankrupt as they are spending “tomorrow’s moneyâ€. Which basically means these people are not saving or building their retirement nest.
Ideally, Ong says, people should start saving from the time of conception; that way would be able to enjoy the magic of the compounding effect (see Chart 2).
Prudential’s Tan says a noticeable trend is that while the younger generation is prepared to invest in new financial instruments, the older generation gravitates towards fixed deposits.
“That is very risky because you would not be able to accumulate enough because the interest rates can’t meet the inflationary rate and your money is getting smaller,†he says.
He believes given the current life span, it would do retirees good to be more aggressive in their investment.
“In investing, you should not be looking at the date of retirement but rather the date of potential death which is probably still another 21 years away after retirement,†he says.
He recommends that people only keep about six months of their monthly expenses in the savings and FDs and put the rest in investment products that generate more income than the inflation rate.
Ng believes a good private pension would help people in their retirement years. In developed countries, money put into savings for retirement is not taxable, neither is the profit from that investment.
“When you retire, you can’t take the money out in a lump sum either or you’d have to pay tax on it. This will force you to withdraw your money on a regular monthly basis for retirement because that’s tax free,†he adds.
Singapore has such a scheme, the voluntary Supplementary Retirement Scheme, which complements the Central Provident Fund (CPF). Such a scheme has not taken off in Malaysia for a number of reasons, says Ng.
It would be a loss of revenue to the Government because people would not be paying taxes on money put aside for retirement. It would benefit only the rich and middle income group as the poor might not be able to afford it, he adds.
“Perhaps it hasn’t taken off too because the Malaysian economy is pretty dependent on consumer spending. And the Government wants you to spend,†he adds.
Ng says there should also be an asset liquidation law in the country. It is puzzling that there are all sorts of incentives for asset accumulation, he says, but none for liquidation.
An example of asset liquidation would be to reverse mortgage your house to the bank in return for a guaranteed monthly income until you die.
The asset would at the end of the day belong to the bank or insurance company. But in the meantime, the person has the right to continue to live in the house until death and get a monthly income too.
“If they outlive the value of the house, the bank loses,†he says.
As our population ages and life expectancy increases, more thought must be given by both individuals and the Government on how to develop a culture of planning and saving for one’s retirement.
Philosophy of the Stock Market
Once upon a time in a village, a man appeared who announced to the villagers that he would buy monkeys for Rm 10. The villagers, seeing that there were many monkeys in the forest, went out and started catching them.
The man bought thousands at Rm 10 and as supply started to diminish and villagers started to stop their efforts, he announced that now he would buy them at Rm 20.
This renewed the efforts of the villagers and they started catching monkeys again. Soon, the supply diminished even further and people started going back to their farms.
The offer rate increased to Rm 25 and the supply of monkeys became so that it was an effort to even see a monkey, let alone catch it.
The man now announced that he would buy monkeys at Rm 50. However, since he had to go to the city on some business, his assistant would now buy on behalf of the man.
In the absence of the man, the assistant told the villagers, “Look at all the monkeys in the big cage that the man has collected. I will sell them to you at Rm 35 and when the man comes back, you can sell them to him for Rm 50 each.”
The villagers queued up with all their savings to buy the monkeys.
After that, neither the assistant nor the businessman could be found anywhere but the monkeys were everywhere!
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