Finding value as a Singapore investor through investing in portfolio of global ETFs

EX ANTE RETURNS FROM A PORTFOLIO OF ETFs

PREPARED BY:Alvin NEO

LEE Xuan DeLIM Jun HaoJeffrey TANGWayne KANG

Retail investors are prone to making these basic investing mistakes, cumulating in them putting all their eggs in the same basket. This increases the risk that they are exposed to.

Introduction

Singapore investor investing in Singapore equity,

while holding on to Singapore based jobs and living in

Singapore based property.

Home Biasness

Singapore retail investors tend not to diversify out of

a few equity or bonds. This may be due to lack of

knowledge or hassle involved.

Lack of Diversification

Due to home-biases, Singapore investors rarely trade

in overseas where returns are on average higher,

albeit with higher risks.

Non-participation

Exchange Traded Funds1. High Diversification

2. Low Fees3. High Variety4. Easy Access

Ex Post SPDR STI ETF Returns

-25.0000%

-20.0000%

-15.0000%

-10.0000%

-5.0000%

0.0000%

5.0000%

10.0000%

15.0000%

20.0000%

25.0000%0

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8 years average monthly return 0.568%

8 years annualized return 7.034%

Criterions of Selection

Sufficient History

Sufficient history provides

more information for

analysis of ETF.

Liquidity

A high liquidity ensures that the bid-

ask spread of the ETF is low, which

does not erode our total yield.

Low Correlation

To avoid home biasness, ETFs

selected should be of low

correlation with STI Index.

Geographical SpreadGreater geographical spread

ensures that our portfolio is less

affected by regional problems.

Positive Sharpe RatioPositive Sharpe ratio indicates

positive excess returns for

amount of risk taken

Large Fund SizeLarge market capitalization reduces

tracking error of ETF, thereby

decreasing the transaction cost.

Methodology

Universe of ETF Positive Sharpe Ratio

High Liquidity

Sufficient History Large Fund Size Low Correlation

Pool of Portfolios to pick from

Asset Classes

ETFs that trade primarily in stocks of companies. Further separated into large, med and small cap

Equity

ETFs that hold assets dealing with commodities related items. Yields are sensitive to market news.

Commodities

ETFs that hold on to underlying assets relating to the healthcare industry

Healthcare

ETFs which hold bonds from various companies and governments.

Bonds

The asset class of an ETF determine its underlying risk profile, which

provides an indication of the possible level of yield the ETF is able to return.

iShares Core US Aggregate Bond (AGG)

Components of Our Portfolio

AGG consists mainly of US treasury

securities and bonds of US large-cap

companies providing stability to the

portfolio

iShares JPMorgan USD Emerging Markets Bond (EMB)

EMB provides investors with exposure to US

dollar-denominated government bonds issued

by over 30 emerging market countries, holding

77.77% worth of sovereign debt.

SPDR Select Healthcare Fund (XLV)

XLV tracks an index of US based

healthcare related equity.

iShares China Large-Cap ETF (FXI)

FXI tracks an index containing 50 of

China’s largest cap firms, listed on the

HK exchange.

iShares MSCI Hong Kong ETF (EWH)

EWH contains a mix of large and mid-size

capped companies, hence moderate risk. Risk

profile is balanced with lower risks large-

capped companies

Energy Select Sector SPDR (XLE)

XLE consists of a basket of equity of large cap energy

related companies dealing with oil, petroleum and

natural gas, with a wide geographical spread.

Geographical Spread

iShares MSCI Hong Kong ETF (EWH)


iShares China Large Cap ETF (FXI)

iShares JP Morgan USD Emerging Markets Bond (EMB)




Large Market Capitalization: US$13.84 billion

Relatively high annualized ex post returns: 7.7416%

Low Expense Ratio of 0.15%

Beta of 0.557

Sharpe Ratio of 0.2233, indicating positive excess returns in

relation to risk undertaken

Low current oil price: $45.72 as of 23rd March 2015

Holdings in equity of companies dealing with oil,

petroleum, gas & natural resources

Reasons for selection

iShares China Large Cap ETF (FXI)

Tracks MSCI China NR Index, invested in equity of China’s 25 largest and most

liquid stocks dealing with array of services including financials, energy,

telecommunications, technology, industrial and utilities.


High annualized ex post returns: 8.6436%

Moderate level expense ratio: 0.74%

Beta of 0.2422, good hedge against local downturns due to

weak correlation




iShares JP Morgan USD Emerging Markets Bond (EMB)

Large Market Capitalization: US$4 billion



Beta of 0.884



High diversification as no single country accounts for more

than 7% of the total ETF

Tracks an index composing of 30 U.S. denominated

emerging market sovereign bonds.



Tracks an index composing of equity of companies dealing with

pharmaceuticals, biotechnology, life sciences, equipment & supplies

Large Market Capitalization: US$110 billion



Beta of 0.789

Sharpe Ratio of 0.6637, indicating high positive excess

returns in relation to risk undertaken

Provides the highest ex post returns due to a booming

healthcare industry.



Tracks an index composing of investment grade US

bonds, giving stability to our portfolio.


Average annualized ex post returns: 5.1005 %

Very Low Expense Ratio of 0.08%

Beta of 0.436



Only invests in investment grade bonds, with over 36%

consisting of US treasury bonds Extremely low default risk.

Acts as defensive cover within our portfolio


iShares MSCI Hong Kong (EWH)

Tracks a market cap weighted index of firms that are

listed on the Hong Kong Exchange.


Average annualized ex post returns: 9.8157 %


Beta of 0.436



Provides a liquid opportunity to gain exposure to the Hong

Kong market, a major Asian financial market. Heavy weightage

in stable financial conglomerates.


Comparison of Chosen ETF with SPDR STI ETF

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Annualised Stdev

Ex Post Overall Returns for SPDR

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SPDR STI ETF

Health Care Select SPDR* Fund

Energy Select Sector SPDR* Fund

iShares Core U.S. Aggregate Bond ETF

iShares China Large-Cap ETF

iShares MSCI Hong Kong ETF

iShares J.P. Morgan USD Emerging Markets Bond ETF

Based on the historical data, we calculated the monthly ex post returns

of each individual ETF, placing SGD $1 for ease of measuring

Ex Post Overall Returns for SPDR

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SPDR STI ETF

Subsequently, we computed the overall portfolio return with the

assumption of equal weightage of our 6 chosen ETFs.

Overall Portfolio

Results:

SPDR STI ETF Our Portfolio

Annualized Return 7.0340% 7.530%

Annualized StDev 20.1734% 16.367%

Beta 1 0.52991

Sharpe Ratio(Risk-free = 2.3%)

0.2347 0.31953

Ex Ante Return

We incorporated a multitude of factors in calculating the

ex ante expected returns for our portfolio:

1.

2.

3.

Ex post returns for each ETF are categorized according to two states of nature, recession and non-recession, determined based on Singapore’s GDP % growth figures. This gives us an accurate historical measure of how the ETF performed during each event.

We computed the future probability of recession based on the theory of yield curve inversion. This provides us with a mathematical basis to compute our ex ante returns.

Sometimes, the past may not accurately represent what may occur in the future. Hence, we have adjusted the predicted returns of each ETF and its weightage within our portfolio based on 5 key future trends that we have identified.

Ex Post Returns

Recession Probability

Trend Analysis

Ex Post Returns on our Portfolio1.

The shaded portion refers to period where recession occurred in Singapore.

Hence, we took the average return of our chosen ETFs from that period as a base

to work with for computing yields during recession period

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Yield Curve Inversion in predicting recessions

Yield curve inversion is widely regarded as an accurate predictor of recessions. The

occurrence of recession will heavily impact most of our ETFs. Hence, it is important

for us to factor in the likelihood of recession in our Ex Ante returns computation.

2.

Recession Probability

We based our computation on the research of Wheelock and Wohar, 2009. Using the formula below,

we plugged in the long term and short term yield of Singapore Treasury bonds to forecast the

recession probability.

2.

Based on our model, the recession probabilty for April 2015 stands at 8.39%

Probability of Recession

Future ForecastDue to the length of analysis (5 years), we project the probabilty of recession to be 15% for our calculation of ex ante returns

Trends

Interest Rate HikeEmerging Market

GrowthCurrency Movements Demographic Shifts Oil Price Outlook

When interest

rates are

increased,

borrowings

decreases, leading

to possible

economic

slowdown

Emergence of

BRIC countries

presents

opportunities for

higher yield

investments

Currency

movements will

determine the

attractiveness of

the home country

Demographic shifts

affect the

profitability of

underlying assets

of various

portfolios,

potentially

affecting their

inevitability

Oil prices have a

macro effect on

various economic

indicators and

yield of energy

intensive sector

ETFs

3.

Based on the trends identified, we sought to rebalance our

portfolio to effectively capture future growth prospects

Ex Ante Reformulation of Our Portfolio

Health Care Select Sector SPDR® Fund

35%

Energy Select Sector SPDR® Fund

18%

iShares Core U.S. Aggregate Bond ETF

8%


18%

iShares J.P. Morgan USD Emerging

Markets Bond ETF11%


10%

Overweight Health Care Select ETF due to optimistic view on earnings of healthcare sector which have most businesses found in aging first-world countries

Overweight iShares China Large-Cap ETF due to favourable future outlook relating to demographics, currencies, strengthening domestic market

Overweight Energy Select Sector ETF because current suppressed prices of crude oil will not remain so in the long run

Rationale

Component Breakdown of Ex Ante Expected Returns

Below is the detailed breakdown of our computation on ex ante

expected returns of our portfolio

Health Care Select Sector SPDR® Fund

Energy Select Sector

SPDR® Fund

iShares Core U.S. Aggregate Bond

ETF


iShares J.P. Morgan USD

Emerging Markets Bond

ETF


Portfolio

Weightage 0.350 0.180 0.080 0.180 0.110 0.100 1.000

Recession Returns

-6.9008% -6.6336% 0.2645% -5.0437% -0.8094% -3.7169% -22.8399%

Non -Recession Returns

6.5358% 2.8918% 0.4287% 2.7169% 1.1854% 1.8687% 15.6274%

Expected Weighted Returns

4.5204% 1.4630% 0.4041% 1.5528% 0.8862% 1.0309% 9.8573%

Computation of Ex Ante Expected Returns

We used the above mentioned three portions to compute our ex ante

expected returns for our portfolio, surmised in our table below

Rs Ps * Rs

State Probability STI ETF Portfolio STI ETF Portfolio

Recession 15% -45.7624% -22.8399% -6.8644% -3.4260%

No Recession

85% 17.5881% 15.6274% 14.9499% 13.2833%

Total 8.0855% 9.8573%

Key Takeaway

By holding onto a portfolio of diversified ETFs, Singapore retail investors

can yield higher returns while undertaking lower risks, as compared to

solely investing in the local market

Annualized Returns Annualized StdevSharpe Ratio (Risk Free

rate = 2.3%)

Weighted Portfolio 9.8573% 13.7356% 0.582309848

STI ETF-only Portfolio

8.0855% 22.6206% 0.255762976

Limitations

As with any projections, there will be limitations. Hence, we

have included a sensitivity analysis:

The magnitude of the yield curve inversion in SG is also not as obvious as that in the US, which may skew our calculations of recession probability.

Slow Yield Curve Spread

Predictions not reality

Our predictions will only hold true if our estimates and macroeconomic trends hold true.

High price

The total price of 1 unit of our portfolio is $ 438.56 at 25/03/15 spot price. Our analysis assumes that our retail investor can afford this price.

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Questions?

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Finding value as a Singapore investor through investing in portfolio of global ETFs