Investing in ETFs

What are ETFs?

Exchange traded funds (ETFs) are investment funds that are listed and traded on a stock exchange. An investor’s money is pooled with money from numerous investors and invested according to the ETF’s stated investment objective1. ETFs are like mutual funds, but whereas mutual fund shares can be redeemed at just one price each day – the closing net asset value (NAV)), ETFs can be bought and sold throughout the day on a stock exchange, which is the same as the case for shares. With investment in an ETF, investors gain exposure to numerous securities in a single investment transaction.

ETFs can cover U.S. and foreign markets, specific sectors, or different assets. Investment in ETFs is a form of passive investment strategy, as the ETF manager only changes the composition of the ETF when changes occur in the underlying index (e.g. S&P500, NASDAQ 100, STI) or companies the ETF manager wishes to track. As such, the ETF is aimed at producing returns that tracks a specific index such as a stock index or commodity index. Conversely, these index tracking ETFs are thereby not aimed at outperforming the index. Investors earn capital gain when the prices of the component shares rise above the initial price paid for them. Simultaneously, some ETFs also pay dividends. While most of the ETFs present in the market are passively managed, actively managed ETFs are also available. Fund managers for actively managed ETFs select stocks and perform frequent trades to outperform the underlying index so as to generate returns. They will modify the compositions within the portfolio according to their views on the market. However, actively managed ETFs are required to disclose their holdings everyday which lead to reluctance in the fund managers to create actively traded ETFs. As such, passive investing is a more popular strategy among ETF investors. In this article, we will be mainly focusing on passively managed ETFs.

Advantages of ETFs

Firstly, investors can gain exposure to an index or a group of companies without having to invest in all its component stocks. This is especially crucial for investors with limited capital. Take the example of NASDAQ-100 Index ETF, Invesco QQQ. For approximately USD$3082, Investors are essentially purchasing a slice of the companies in the NASDAQ-100 Index – a stock market index made up of 103 equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock market. The USD$ 308 investment is a stark contrast to the capital an investor would need if he were to purchase shares of each of the 100 companies. Therefore, ETFs allow investors to reduce their exposure to firm-specific risk and diversify their shareholdings at low-cost.

Secondly, index tracking ETFs have fees and charges that are usually lower than those of actively managed investment funds as ETFs have lower management fees. There is also usually no sales charge, although if investors trade ETFs on stock exchanges such as the Singapore Exchange, would need to pay the applicable brokerage commissions or transfer taxes depending on the brokerage.

Is investing in ETFs a 100% profitable investment?

Just like investing in a company’s shares, ETFs are not principal guaranteed. Investors may lose all or a substantial amount of their capital, depending on the performance of the ETF and therefore the shares which the ETF comprises. Often, the major risks of investing in ETFs are described in the prospectus and product sheet.

Index ETFs

Index ETFs are exchange-traded funds that seek to replicate and track a benchmark index like the Dow Jones Industrial Average, Nasdaq 100 or S&P 500 as closely as possible. 

By purchasing an ETF which tracks a stock index, investors gain exposure to the performance of the index. For example, investing in an ETF that tracks the Straits Times Index (STI) provides investors with exposure to the Singapore market.

Industry ETFs

Industry ETFs are exchange-traded funds that seek to track a benchmark index for specific industry sectors by investing in the stocks and securities in the specific industry sectors. The common sectors which are present are health care, information technology, energy, financials, materials, industrials, consumer staples, consumer discretionary, telecommunication services, utilities and real estate. By investing in industry sector ETFs, investors get to gain exposure to the performance of the whole industry via the industry tracking indexes. Through this narrowed down focus within the overall stock market, investors should be prepared to experience greater volatility in their investments in the particular sector as compared to the overall stock market. Furthermore, among different industry sectors, investors have to be aware of the presence of different risk/reward profiles. For instance, the technology sector has the greatest tendency to exhibit high volatility whilst the utility sector is far more stable and has low volatility. A few well-known Technology Equities ETFs are Vanguard Information Technology ETF (VGT), Technology Select Sector SPDR Fund (XLK) and iShares U.S. Technology ETF (IYW). For Health & Biotech Equities ETFs, Health Care Select Sector SPDR Fund (XLV) and Vanguard Healthcare ETF (VHT) are among the US-traded ETFs in the Health & Biotech category. 

Choosing ETFs

●      Benchmark

As an investor, the most important thing that one should be concerned about is knowing what exactly is the ETF tracking.  By knowing the benchmark, investors will have a better understanding of what they are investing in and the areas affecting the prices. Investors are advised to pick ETFs which are investing in areas that they are familiar and experienced with. 

●      Tracking Errors

Tracking errors are present when there is a difference between the performance of the ETF and the benchmark. It is important to be aware of the tracking errors as high tracking errors will indicate that the ETF is trailing behind the index that is being benchmarked. Investors should choose ETFs which have minimal tracking errors to mitigate large divergence between the performances and achieve close tracking of the underlying indexes.

●      Fund’s Liquidity 

Commonly, an ETF that is able to garner strong investor’s interest has a minimum level of assets of at least $10 million. With the ability to generate strong investor interests, the liquidity of the ETF will be greater and have a tighter spread. Therefore, a viable ETF is recommended to have at least $10 million assets.

Investors should also be clear about the volume of shares being traded daily to understand the ETF’s liquidity. The higher the volume of an ETF being traded, the higher the liquidity, therefore leading to a tighter bid-ask spread. If the ETF chosen is trading below a certain amount of shares per day, the low liquidity acts as a probable obstacle for investors to sell off their ETF easily in the future, especially for short term ETF traders. Therefore, the liquidity of the ETF is a key consideration for investors. 

●      Expense Ratio

Lastly, the cost of an ETF is also a crucial determining factor when picking a desired ETF. An expense ratio is an annual fee that the investors have to pay the fund manager for the administrative and operation expenses. This cost is subtracted from the investor’s invested fund amount which will hence, reduce the returns from the ETF. A high expense ratio may significantly drive down the returns from the ETF in the long run. Passively managed ETFs have an average expense ratio of 0.54%3. Therefore, investors should pay attention to the expense ratio for the ETF they are going to invest in. 

Tax Considerations

For long term investors seeking to inject a huge amount of capital in ETFs, tax considerations might play a huge role in selecting an ETF to invest in. For instance, an ETF tracking the S&P500 index is the SPDR S&P500 ETF (Ticker: SPY), which is traded on the New York Stock Exchange. However, in the United States, there is a 30% withholding tax for foreign investors. This means that for every $1 dividend paid out by the fund, investors only receive $0.70. Such a difference is magnified when the investor invests a huge amount of capital in the ETF and holds the ETF for a long period of time.

One way to get around the tax consideration is to invest in Irish domiciled ETFs, which are also traded on the London stock exchange. Due to the tax treaty between the United States and Ireland, the withholding rate is only 15%. Furthermore, there is no withholding tax imposed by Ireland on Singapore residents. This means that for every $1 dividend paid out, the fund manager in Ireland receives $0.85 in dividend. And since there is no withholding tax imposed by Ireland on Singapore residents, Singapore residents receive the full $0.85

 

In investing in the US domiciled SPY, the net dividend yield after 30% withholding tax is:

 1.62% * (1-0.3) = 1.134%. 

This net 1.134 dividend yield is lower than the 1.38% dividend yield received if the investor were to invest in the Irish domiciled SPY5.L. Therefore, investors seeking to invest a huge amount of capital in the ETF for extended periods of time should take into account tax considerations because the tax savings could be substantial.

The Bottom Line

Investing in ETFs is a relatively stable investment strategy with reasonable yields. Take the example of the S&P500 – average annualized total return for the S&P 500 index over the past 90 years is 9.8 percent, which is substantially higher that what individuals earn in fixed deposits. However, investors still have to take note of the risk of capital depreciation and invest only if they are comfortable with this risk. Furthermore, since there are numerous ETF managers out there seeking to track the same index or industries, investors should do their due diligence and take caution in selecting an ETF provider in order to maximise their returns by minimising unnecessary costs.

References

1 https://www.moneysense.gov.sg/articles/2018/10/guide-to-etfs-understanding-exchange-traded-funds

2 As of 16 December 2020

3 https://www.etftrends.com/in-fund-industry-fee-war-etf-investors-win/

4 https://www.youtube.com/watch?v=gTdhVsT7CVo&ab_channel=TheFifthPerson

REITs – What Are They & What to Look Out For?

By Huang Zixun

A Real Estate Investment Trust (REIT) is an investment fund that pools investors’ capital to own and operate real estate properties. After deducting management fees, the income generated from leasing or renting out those properties is then redistributed to the investors in the form of dividends, with the technical term being distributions. Most REITs specialise in managing one form of real estate, with notable sectors being commercial, industrial, retail, and healthcare.

Why REITs?

Graph of average 5-year forward distribution (dividend) yield of the FTSE ST REIT Index. Source: OCBC Investment Research

Graph of average 5-year forward distribution (dividend) yield of the FTSE ST REIT Index. Source: OCBC Investment Research

One unique factor of REITs would be the legal requirement to distribute at least 90% of its taxable income, resulting in a relatively higher dividend payout ratio as compared to equities, which is a key selling point for investors. As seen in the graph above, the 5-year average forward distribution yield for Singapore mainboard-listed REITs (S-REITs) amounts to 6.3%, as compared to the equities-heavy STI average of around 3.8%. This high distribution resulting in higher dividend income would be especially attractive to dividend investors pursuing a long term buy-and-hold strategy.

In addition, REITs offer investors an opportunity for increased portfolio diversification. Since REITs are publicly traded, they enable investors to have a more liquid form of property investments instead of direct property ownership. Furthermore, the vast majority of REITs own and operate multi-property portfolios which reduces investors’ risk of relying on a single property’s performance. With REITs being professionally managed by property management companies, many investors buy into REITs to reduce unsystematic portfolio risk.

What Factors Influence REIT Price & Distribution?

Despite the benefits, there are some factors that investors need to keep in mind before making any investment decisions. The factors can be broadly categorised into external market and internal risk factors.

1. Market & Industry Conditions

Similar to equities, REITs’ prices are affected by market demand and supply conditions. This can represent investor sentiment about general market conditions, such as bull or bear markets. It can also reflect property market changes, such as if the government were to raise or lower property taxes. REITs that hold properties centred on a specific industry would also be affected by industry-specific developments, such as retail slowdowns affecting retail-centred REITs.

2. Interest Rates

Focusing on one specific market factor, one of the more underrated factors affecting REIT performance and distributions would be interest rates. For equities, rising interest rates would normally lead to lower stock prices, as investors are incentivised to put their capital in bonds due to the relatively higher yield for bonds and perceived lower risk. This causes a lower demand for equities which causes a resulting fall in equity prices. For the same reasons, this drop in price is also true for REITs in the short run.

Correlation of REITs returns with rising interest rates. Source: Nareit

Correlation of REITs returns with rising interest rates. Source: Nareit

However, in the long run, as seen in the graph above, REIT returns are on average, positively correlated with interest rates. One reasoning behind this is that rising interest rates are indicative of a healthy economy. REITs would thus have their occupancy rates increased due to higher business confidence, and they would also be able to increase rental rates for those tenants. This causes their revenues to rise which results in higher average rates of returns. As such, during interest rate hikes, even though REITs fall in price initially, they increase long-term shareholder returns, and vice versa.

3. Income/Distribution Risk

Keeping in mind that the key differentiating factor of REITs from equities is their relatively higher dividend income generated, the value of REITs thus highly depends on their distribution yield. As the distributions are not guaranteed and can vary, REIT investors face a form of income risk. In fact, in the unfortunate event that the REIT suffers a net loss, dividends may not be paid out at all. Thus, the distribution yield itself represents the REIT’s long-term profit sustainability, and is a highly important factor in determining the share price and fair value of the REIT in question.

4. Refinancing Risk

Due to the 90% rule mandating that REITs need to distribute the majority of its profits to shareholders, they would not have large amounts of cash reserves. This causes REITs to have a high reliance on borrowed capital such as bank loans. This high rate of borrowing leads to higher interest rates in the long run due to their increased leverage risk, and causes potentially lower distributions due to reduced income. Furthermore, if a REIT is unable to generate sufficient capital to service its loan repayments, it may be forced to sell off the properties if they are mortgaged under the loan, thus reducing the asset’s value.

5. Concentration Risk

This relates to how many properties are under the REIT’s management, as well as the depth of their tenant mix. REITs that hold fewer properties and have a smaller group of tenants are easily affected by any changes in market developments, whether positive or negative. To give an example, the SGX-listed Lendlease Global Commercial REIT has a relatively high concentration risk with only 2 properties under management: Sky Complex in Milan and 313@Somerset in Singapore. The COVID-19 pandemic resulted in Milan being one of the worst-hit areas, as well as a fall in demand for retail in Singapore. This resulted in a drastic fall in the unit price by around 46% in the span of just 1 month.

What To Look Out For?

Based on the overview of some of the external and internal factors affecting REIT price and distribution, here are 3 main elements that an investor can use to analyse the value of a particular REIT.

1. State of the Economy & Industry

In general, a stronger economy is better for REITs as it ensures the financial health and stability of their tenants thus improving the REIT’s profitability. As mentioned earlier, interest rate changes in particular affect REITs significantly. Thus, investors should keep an eye out for the overall health of the economy as well as any interest rate changes.

S-REITs Holdings by Country & Industry. Source: SGX Research

S-REITs Holdings by Country & Industry. Source: SGX Research

From the figure above, the majority of S-REITs operate in multiple countries, meaning investors often have to consider the economy of more than one country. Furthermore, industry-specific factors are also important for an investor’s consideration due to the varied property sub-segments that REITs have. For example, for hospitality REITs, investors need to look at the tourist growth outlook for the countries the REIT’s hotels are in. Doing research on these broad economy and industry factors can help investors identify opportunities and reduce the likelihood of being caught out by sudden changes.

2. Quality of Portfolio Holdings

Zooming into the more specific micro factors, before investing, investors need to have an understanding of both the value and sustainability of the REIT’s income stream from each of its holdings. Firstly, to ensure the REIT has a high-value income stream, investors should analyse if those properties are in a high-growth location and sector. REITs with properties in prime locations and in a fast-growing sector would have higher tenancy rate and income, allowing them to increase their distribution yield and make them more attractive to investors.

Secondly, one metric commonly used to analyse if the REIT has a sustainable income stream would be the Weighted Average Lease Expiry (WALE). This is measured by weighting all tenants’ remaining lease in years with either the tenants’ occupied area or rent. This metric is commonly used to assess the likelihood that the property holding will go vacant. In general, the higher the REIT’s WALE across its properties, the more certain its profits are in the short-medium term. However, it is important to note that commercial REITs usually have a shorter WALE as retail tenants usually commit to shorter leases compared to companies leasing out office or warehouse space.

Overall, understanding the underlying quality of a REIT’s property holdings can enable investors to choose REITs with lower redistribution and concentration risk. This would likely translate to long-term sustainability of distributions and capital growth.

3. Fundamental Analysis

Typically, this is used to assess a stock’s fair value. For REITs, 3 key metrics can be used to perform a basic fundamental analysis to assess the REIT’s attractiveness relative to the market average.

Firstly, the distribution yield directly impacts investors as it determines their income stream from the REIT. This means it is often the foremost metric investors use when making investment decisions for REITs. Furthermore, it gives an insight to the overall financial health of the REIT as REITs with higher distribution yields usually have higher profitability. The average distribution yield for S-REITs is around 5-7%.

Secondly, the gearing ratio is an important metric to determine a REIT’s long-term financial health. This measures the ratio of a REIT’s debt to its total assets, and for S-REITs, there is a maximum regulatory limit of 45%. In general, investors prefer lower figures as it signals lower refinancing risk for the REIT. For S-REITs, the average gearing ratio is around 32-38%.

Thirdly, Net Asset Value (NAV) can be compared with the REIT’s price to form the Price/NAV ratio. This ratio is used to assess whether a REIT is priced fairly relative to its valuation. Price/NAV below 1 signals undervaluation, while a value above 1 signals overvaluation. In general, investors consider a healthy figure to be around 0.8-1.2. However, a Price/NAV of less than 1 may be indicative of certain forms of distress or poor outlook which means the REIT is not undervalued in reality.

Conclusion

Overall, REITs are attractive to investors because of the reliably high dividend yields compared to equities. However, just like individual equities, they are susceptible to many risk factors as well and depending on the REIT, would constitute moderate to high risk investments. Investors looking at a lower risk vehicle for REITs could hence consider REIT Exchange Traded Funds (ETFs) such as the Lion-Phillip S-REIT ETF as non-systematic risk is diversified away.

Meanwhile, investors looking at individual REITs should undertake due diligence and research before committing to any investment decisions. This article’s explanations regarding the influencing factors and aspects to look out for can serve as a primer for decision making, but are not meant as an exhaustive list. Every investor’s portfolio composition and risk appetite is different, hence the ultimate deciding factor for investors should be how much the REIT can value-add to their portfolio.

References:

REITs Concept & Definitions – https://www.moneysense.gov.sg/articles/2018/10/understanding-real-estate-investment-trusts-reits

Investor’s Guide to REITs – https://www.reit.com/sites/default/files/media/PDFs/UpdatedInvestorsGuideToREITs.pdf

Benefits of REITs – http://news.morningstar.com/classroom2/course.asp?docId=145579&page=2

REITs Pros & Cons – https://portal.iocbc.com/products-services/reits.html

S-REITS Overview – https://www.reitas.sg/singapore-reits/overview-of-the-s-reit-industry/

OCBC S-REITS Overall Analysis – https://www.ocbc.com/assets/pdf/media/2019/singapore%20reits%20-%20a%20shelter%20for%20the%20doves%20and%20uncertainties.pdf

STI Average Dividend Yield – https://www.straitstimes.com/business/companies-markets/annualised-total-returns-of-92-over-10-year-period-for-sti

REITs & Interest Rates – https://www.reit.com/investing/reits-and-interest-rates

REITs & Interest Rates – https://www.cnbc.com/2018/05/30/rising-rates-it-may-be-time-to-buy-not-sell-those-reits.html

Equities & Interest Rates – https://www.thebalance.com/how-rising-global-interest-rates-impact-international-stock-markets-4158038

Risks of REITs – https://www.poems.com.sg/market-journal/understanding-3-key-risks-of-reits-and-adding-s-reits-to-your-portfolio/

SGX Research REITs Charbook – https://www.reitas.sg/wp-content/uploads/2020/02/SGX-Research-SREIT-Property-Trusts-Chartbook-February-2020.pdf

Weighted Average Lease Expiry (WALE) – https://www.reitsweek.com/2013/05/weighted-average-lease-to-expiry-wale.html

The Basics of Investing in Small, Mid, and Large-cap Stocks

By Muskaan Ahuju

Morningstar defines large-cap companies as those that account for the top 70% of the capitalisation of a domestic stock market. Mid-cap stocks represent the next 20% and small-cap stocks make up the remainder. Companies are classified as large-, mid- or small-cap based on their market capitalisation, which is calculated by multiplying the share price by the number of shares outstanding. Simply put, market capitalisation represents a company’s dollar market value.

In Singapore, the FTSE ST Large & Mid Cap index comprises of large and mid-cap stocks, and it makes up about 86% of the Singapore market capitalisation. Companies on the STI are also included in this index. Well-known names like DBS Grp, Singtel, OCBC Bank, CapitaLand Ltd., etc make up the list of large-cap stocks. These tend to be large, established organisations, and their market capitalisation is generally above $10 billion.

Meanwhile, mid-cap stocks represent a market capitalisation between $1 billion to $10 billion. Apart from the FTSE Large & Mid Cap Index, the FTSE ST Mid Cap Index also comprises of mid-cap shares. It is a market capitalisation weighted index that tracks the performance of the next top 50 Companies (after the STI constituents) listed on SGX. Some examples of Singapore mid-cap stocks are SBS Transit, United Engineers, Yanlord Land Group, Sheng Siong Group, etc.

Lastly, the FTSE ST Small Cap Index tracks the performance of companies listed on SGX that are within the top 98% (by market capitalisation), except for those included in the STI and FTSE ST Mid Cap Index. These have a market cap of less than $1 billion. Some examples are Breadtalk, Federal International, etc.

Given the information about classification of shares by market cap, an investor is faced with the dilemma of investing in the share-type best suited for his needs, as different share types offer vastly different risk-return profiles. In times of economic instability and market upheaval, a company is bound to have periods where the stock loses value. In such a scenario, looking at the overall stability of a company’s stock is important. A great deal of fluctuation, more often than not, is a red flag. If, however, the loss in stock value is a result of worsening market conditions, you may want to consider the stock.

In a market ripe with an abundance of stocks to invest in, it is important to hand pick those that best suit your needs as an investor. The first step to doing so is learning about the pros and cons of each type of share, and some considerations have been listed out below.

1. Growth Prospects

Small-cap stocks are attractive for their growth prospects. However, their growth may be outshined by mid-caps as they generally feature strong management and seasoned business practices, and hence their growth comes with less volatility and faster rates with this added advantage of financial stability. In contrast, large-cap stocks may have relatively limited growth potential as it is in general harder to improve and grow a well established company than a smaller one.

To gauge the sustainability of growth, indicators such as free cash flow, earnings growth, debt-to-equity ratio and price-to-earnings ratio can be used. In 2019, the STI had a 5% YoY growth, which was lower compared to the FTSE ST Mid Cap Index and FTSE ST Small Cap Index with 11% and 8% YoY growth respectively.

However, it is important to note that higher risk does not always equate to higher returns. This is reflected in the under performance of the FTSE ST Catalist Index, which consists of fast-growing companies listed on the Singapore Exchange’s (SGX) junior board and had a YoY growth rate of -12%.

 

2. Risk

Amongst the three types of shares, large-cap shares are the least risky due to their strong financial health and strong state of operations. Mid-cap companies pose some risk as there is always a chance of a merger or acquisition with bigger companies. Furthermore, investing in mid-caps requires an investor to analyse the sustainability of growth prospects. Small-cap stocks are the most risky, as they are the first to falter in times of economic downturns and come with significant levels of volatility.

 

3. Availability of information

Large and mid-cap stocks are analysed by a plethora of analysts, making research and information abundantly available for investors. This can assist an investor in making a well-informed decision. However, it also means that it is harder to find a mispriced stock and buy it at a discount. Large and mid-cap stocks are almost always fairly priced. On the contrary, small-cap companies are less known, and it is possible for an investor to find a mispriced security.

 

4. Dividends

Large-cap companies, at large, are better equipped to pay out dividends due to the strong economies of scale facilitated by widespread operations. This is also an indicator of stability. Dividend payouts are an attractive feature to many investors. However, one should be wary of disproportionately high dividends as this means a company is not reinvesting to improve its operations. While many small and mid-cap companies don’t pay dividends, or only pay a minimal amount due to their need to reinvest, they still remain an attractive option in terms of growth potential

 

Overall, these factors are some very basic considerations that can aid an investor in making a well-informed decision! An investor should consider his time horizon and risk appetite while choosing stocks. Furthermore, it is ideal to choose stocks of varying market capitalisations that can help further diversify the portfolio and mitigate risks.

 

References

https://www.moneyobserver.com/opinion/why-small-caps-should-be-big-consideration

https://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2013/02/22/stock-picking-7-things-you-must-know-about-a-company

https://www.morningstar.co.uk/uk/news/105769/investing-in-small-mid-and-large-cap-stocks.aspx

https://sginvestors.io/sgx-mygateway/2019/03/sgx-mid-cap-stocks-that-averaged-10pct-gains-over-the-past-10-weeks

https://www.tradingview.com/markets/stocks-singapore/market-movers-large-cap/

http://news.morningstar.com/pdfs/FactSheet_StyleBox_Final.pdf

https://www.ftserussell.com/products/indices/sgx-st

https://sginvestors.io/sgx-mygateway/2019/03/sgx-mid-cap-stocks-that-averaged-10pct-gains-over-the-past-10-weeks

https://www2.sgx.com/indices/products/ftfstlm

https://www.straitstimes.com/business/companies-markets/catalist-index-to-include-14-more-stocks

A Guide on Palm Oil Jargon and Other Considerations in Selecting Palm Oil Counters (Part II)

By Ong Xien Fong

After explaining the significant processes of palm oil production, this article will cover four other important points to consider when picking palm oil counters.

1. Correlation to Crude Palm Oil (CPO) Prices

Some investors use the correlation of share price to CPO prices to determine which counters to buy. The logic from this method stems from the fact that CPO is the predominant product of palm oil producers and the increase in prices of CPO would result in an increase in the share price of the palm oil counters as well. The variation in correlation of different palm oil counters can be vast. This can be seen from the correlation bar chart (below) of 3 different SGX counters and CPO prices.

To those who are less familiar with this comparison, correlation can be calculated using Excel by using CPO prices and share prices as the two arrays of data. CPO prices can be obtained as mentioned in part I of this article while historical share prices can be downloaded from Yahoo finance. Correlation ranges from +1 to -1 with +1 being perfectly correlated, -1 being perfectly negatively correlated and 0 being uncorrelated.

Graph of Share Price against CPO Price and Linear Regression. Bar Chart of Correlation of CPO Prices and Share Price. Prices are over a 10 year horizon except for 1 company (due to the date of listing). Source: Yahoo Finance, S&P Capital IQ

Graph of Share Price against CPO Price and Linear Regression. Bar Chart of Correlation of CPO Prices and Share Price. Prices are over a 10 year horizon except for 1 company (due to the date of listing). Source: Yahoo Finance, S&P Capital IQ

It is noteworthy however, that this method is not foolproof. Counters that are less correlated may indicate good hedging/ diversification done by the company and can be better long term investments. Even for a short-term basis, a historically high correlation may not mean share prices would always move accordingly.

As seen in the chart below of relative percentage performance, Company A’s share price did not increase despite Company A having the highest correlation between CPO and share price of the 3.

In fact, other factors such as market sentiment on the counter, restructuring, etc may have a greater impact on the counter. Hence, a high correlation may not always be a good thing, and should definitely not be the only factor in picking palm oil counters.

Relative performance of the respective shares (%). Source: Yahoo Finance

Relative performance of the respective shares (%). Source: Yahoo Finance

2. Research and Development (R&D)

Certain companies have R&D arms. This is important, as certain strains of palm trees have a much greater yield. These strains are often proprietary as well.

To illustrate my point, I would use Golden-Agri Resources (GAR) as an example. GAR announced a breakthrough in research with EKA 1 and EKA 2 strains of palm seedlings. These varieties are expected to be harvested within 24 months as opposed to the average of 30 months. Furthermore, EKA 1 and EKA 2 are expected to produce 10.8 tons and 13 tons of CPO per hectare respectively. This is much higher than the current GAR average of around 8 tons of CPO per hectare.

However, it is important to note that R&D breakthroughs may not bring about rapid increases in production. This is due to two issues: production constraints for seeds, and their rate of replanting. For GAR, it is likely that large quantities of EKA 1 and EKA 2 would only materialise in 2022.

However, research and use of high yielding varieties are only one side of the coin. It is important that plasma holders cultivate the seedlings under great care to obtain their maximum potential. Hence, management and education of plasma holders is paramount (especially since some palm oil counters have a high proportion of plasma holders).

3. Biodiesel

Policies related to biodiesel are one of the most important factors influencing palm oil prices.  On January 2018, the EU voted to ban biodiesel by 2020. The complete ban was then later postponed to 2030. To make up the shortfall in demand, both Indonesia and Malaysia have implemented biodiesel mandates. Indonesia seems to be more aggressive in rolling out biodiesel as compared to Malaysia. Currently, Malaysia has a B10 (10% palm methyl ester and 90% diesel) mandate with plans to implement B20 by 2020. In contrast, Indonesia already has a B20 mandate and seeks to implement B30 by next year, with the ambition to use B50 biodiesel by the end of 2020.

Those who have compared Malaysian listed counters (i.e. KLSE listed counters) with SGX listed counters (Indonesia based plantation) before would know that Malaysian counters trade at a premium compared to Indonesia based companies. It may be tempting to consider Malaysian counters as their shares command a better price even in a low CPO price environment. This also means that Malaysian palm oil counters are generally less correlated to CPO prices as compared to Indonesia based plantations.

However, in light of rising CPO prices and an aggressive Indonesia biodiesel policy, it may be worthwhile to consider Indonesia based palm oil counters on SGX as opposed to KLSE listed counters.

4. Round Table of Sustainable Palm Oil (RSPO) Certification

RSPO is a Non-Government Organisation (NGO) which seeks to unite stakeholders in the palm oil industry. It has a set of social and environmental criteria to fulfil for companies to obtain certification. RSPO certification for plantations are done every 5 years and are audited annually for compliance.

In the midst of investing, let us not forget the potential environmental impact of unsustainable palm oil plantations – especially the haze which is a problem we face from time to time. Before investing be sure to check if the company has any form of sustainable certification!

For those who are still unconvinced with investing in sustainable companies, do bear in mind dire economic consequences may result for such companies. Indofood Agri Resources were sanctioned for flouting RSPO standards and Indonesia law, and the company subsequently withdrew its RSPO membership. In response, Citibank cancelled its revolving credit facility with Indofood Agri Resources. RaboBank has also terminated its financing facility for Indofood Agri Resources and Standard Chartered has dropped the aforementioned company as a client.

Conclusion

To conclude, let us bear in mind the 4 considerations in choosing palm oil counters. Correlation to CPO prices is a simple method to use but that should not be the sole consideration. Furthermore, it would be ideal to consider the R&D pipeline of respective companies on top of comparing current yields between companies. In this current environment, Indonesian based plantations (listed on SGX) may be preferable to Malaysian listed counters. Last but not least, do check for sustainable certification!

Disclosure: Views shared on this article are for educational purposes only. Views do not indicate or insinuate any investment decisions readers should undertake and should never replace investment advice given by an investment professional. The author’s views do not represent the views of Nanyang Technological University.

References:

Citigroup, Standard Chartered, And Rabobank Cancel Substantial Loans To Palm Oil Company Indofood Over Labor Abuses. Will Others Take A Stand?: https://www.ran.org/the-understory/citi-divests-from-indofood/

EU Ban on Palm-Based Biodiesel to Negatively Impact Europe-Asia Vegoil Trade: https://www.hellenicshippingnews.com/eu-ban-on-palm-based-biodiesel-to-negatively-impact-europe-asia-vegoil-trade/

Golden-Agri Resource Subsidiary Cultivates New Palm Oil Seedlings for Better Yield: https://www.straitstimes.com/business/golden-agri-resource-subsidiary-cultivates-new-palm-oil-seedlings-for-better-yield

Indonesia’s Biodiesel Plan Fires Up ‘Red Hot’ Palm Oil Prices: https://www.ft.com/content/ead601a6-ff15-11e9-b7bc-f3fa4e77dd47

Malaysia Plan B20 Biodiesel Blending Mandate By 2020: https://biofuels-news.com/news/malaysia-plan-b20-biodiesel-blending-mandate-by-2020/

Palm Oil: Indonesia and Malaysia Push Back as EU Clamps Down: https://asia.nikkei.com/Spotlight/Asia-Insight/Palm-oil-Indonesia-and-Malaysia-push-back-as-EU-clamps-down

Palm Oil To Rise To RM2,400 A Tonne, On Higher Biodiesel Mandate: https://www.nst.com.my/business/2019/03/466178/palm-oil-rise-rm2400-tonne-higher-biodiesel-mandate

Roundtable on Sustainable Palm Oil: https://rspo.org/certification

The Chain: Mizuho and Mandiri Replace Rabobank, Citigroup and Standard Chartered for Indofood Credit Facilities: https://chainreactionresearch.com/mizuho-and-mandiri-replace-rabobank-citigroup-and-standard-chartered-for-indofood-credit-facilities/

A Guide on Palm Oil Jargon and Other Considerations in Selecting Palm Oil Counters (Part I)

By Ong Xien Fong

Graph of monthly CPO prices. Source: S&P Capital IQ

Graph of monthly CPO prices. Source: S&P Capital IQ

With rising Crude Palm Oil (CPO) prices, palm oil counters are receiving renewed interest again. Despite still being far from historic highs, some palm oil counters have dramatically increased in price recently. However, evaluating palm oil counters is not easy due to the many jargon used in reports. When I first reviewed investor presentation slides a while back, I remembered having to repeatedly Google the various jargon to try and understand the entire palm oil production process. This two part article series aims to help those interested in understanding the palm oil business so as to invest in palm oil counters. In this first part, jargon and processes would be covered to provide a foundation towards understanding the industry.

Source of CPO Prices

There are various sources of CPO prices available on the internet. This is because different exchanges may quote different prices. For this article, the author used CPO settlement prices from the Kuala Lumpur Stock Exchange (KLSE). Future CPO (FCPO) prices from the KLSE are also traded on the Chicago Mercantile Exchange (CME) Globlex. FCPO from KLSE was used due to the ready availability of prices and the close proximity to palm oil production in the region.

FCPO is a Malaysian Ringgit denominated CPO future traded on KLSE since 1980. Contracts are physically settled with a contract size of 25 metric ton of CPO. As both the Ringgit and Rupiah have depreciated against the USD over the years, it is best to caution against using CPO prices quoted in USD to filter out forex movements.

In this article, CPO prices were taken from S&P Capital IQ, a paid platform. CPO prices can also be monitored for free from the Malaysian Palm Oil Council (MPOC) page or from Business Insider.

A simplified flowchart of the processes in the palm oil industry.

A simplified flowchart of the processes in the palm oil industry.

The above is a simplified flowchart on the entire process of palm oil and its products. Some parts of this process will be further explained later.

Comparison of Profit Margin Across Segments

Palm oil companies often report revenue from two segments:

1. Plantation/ Mills

2. Refinery/ Palm Laurics and Others

In order to decrease dependency on palm oil prices, there has been an increasing trend towards increasing revenue from downstream operations (Refinery). This trend gives the impression that downstream operations may be more profitable even though that may not be the case.

According to a business analyst from Toptal, upstream business (Plantation/ Mills) is actually the most lucrative (accounting for 50-60% profit of the value chain) followed by downstream oleochemical processing (15-25% profit of the value chain). The author has found this to be consistent with two large palm oil companies listed on SGX as well.

Graph of EBITDA margin across segments. Source: Bloomberg

Graph of EBITDA margin across segments. Source: Bloomberg

As seen in the graph above, both Golden Agri-Resources and First Resources have much higher margins for the upstream business (plantations and palm oil mills) than their downstream business. For Golden Agri-Resources, ‘Palm, Laurics, Oilseeds & Others’ in their reports refer to “processing and merchandising of palm and oilseed-based products” and “production and distribution of other consumer products” (their downstream business).

Given that the upstream plantation business is the most lucrative, we would now delve into deeper insights into the jargon and processes.

Understanding Significant Jargon and Processes

Screenshot of investor presentation slides from First Resources.

Screenshot of investor presentation slides from First Resources.

The above image is part of an investor presentation slide. Such jargon are not uncommon and are important in making an investment decision in palm oil companies. The following part of the article will explain all the above jargon. If the below is too technical, fret not! These jargon are summarised in the second last paragraph.

1. Milling

After planting and harvesting, milling is the next process that is undertaken for the creation of palm oil (see flowchart). Milling is often done in close proximity to the plantation as Fresh Fruit Bunches (FFB) must be processed within 24 hours to prevent degradation of the oil. Steam is used to sterilise the fruits, soften the flesh and deactivate enzymes which would degrade the oil. The loose fruits are then crushed to produce oil (later further processed to become CPO), nuts and Palm Kernel Meal (PKM). The nuts are then used to produce Palm Kernel Oil (CKO). PKM is protein and fibre rich and is often used as animal feed, fertiliser or fuel for the milling process.

2. Crude Palm Oil vs Palm Kernel Oil

Crude Palm Oil (CPO) is oil derived from the flesh of the fruit while Crude Kernel Oil (CKO) is derived from the oil of the nut. Unrefined CPO is liquid at room temperature and is red. The end product (refined) CPO is the cooking oil we commonly use. On the other hand, PKO is solid at room temperature due to its high content of saturated fats.

CPO is the predominant product; for every 10 parts of CPO produced, 1 part of CKO is produced. Hence, CPO prices are often used as a leading indicator on how palm oil companies will perform.

3. Nucleus vs Plasma

Plasma holders are small independent farmers who agree to sell their fruits to a larger company. In exchange, these farmers enjoy benefits such as advice on plantation techniques, micro-financing (important for replanting efforts) and higher yielding strains of palm trees. In contrast, Nucleus plantations are maintained and held by the company itself.

Apart from the symbiotic relationship between plasma holders and palm companies it is noteworthy that companies have a plasma obligation under Indonesian law. Under Permentan No. 26/2007, plantations license (Izin Usaha Perkebunan (IUP)) for over 250 hectares issued after 2007 must provide 20% of land to local communities to be plasma holders. Companies with IUPs before 2007, though not obligated, must show evidence of improving local community lives.

4. Age of Plantations

Palm oil companies often provide a breakdown of the age of their plantations. But how much does production change for each phase of the life of a palm tree?

Commercial harvesting starts out at 3 years and production starts to rapidly increase thereafter. The optimal is then achieved from 8-18 years followed by a gradual decline in production. The commercial timespan of palm trees is about 25 years. Plantation with older trees face a double whammy; lower production yields and higher cost of harvesting.

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The million dollar question currently is the optimal age for replanting. Unfortunately, there is no easy answer to that as there are numerous factors. At the basic beyond the optimal yield, the primary consideration is the expected future prices of palm oil and how long the high prices will last. High prices that are expected to last long will result in shorter optimal replanting as profit from future palm trees will be more than if no replanting was done. If high prices are not expected to last long, replanting should be postponed to maximise profit. Furthermore, replanting is not cheap due to the cost of planting, financing issues and lost in income.

If the 4 jargon are still too hard to comprehend, in essence, milling is the first step of processing. CPO, the predominant product, is the cooking oil we use while CKO is oil solid at room temperature. Nucleus is plantation owned by the company while plasma is owned by smallholders who agree to sell to a certain company in exchange for financial or other forms of assistance. The optimal age of fruit production for palm trees is between 8-18 years.

To conclude, this article covered the significant processes of palm oil production. Common jargon in investment materials such as CPO and CKO were also covered. In the next part of this article, you will learn other important considerations for selecting palm oil counters.  Look out for the next part to find out more!

Disclosure: Links from the website are not related to NTU-IIC nor the author. The author merely seeks to advise the readers on where to derive data and is not paid by the above links and would not be responsible for any loss, damages or pricing inaccuracies from the above links. Views shared on this article are for educational purposes only. Views do not indicate or insinuate any investment decisions readers should undertake and should never replace investment advice given by an investment professional. The author’s views do not represent the views of Nanyang Technological University.

References:

Alam, A S A Ferdous & Er, Ah Choy & Begum, Halima. (2015). Malaysian oil palm industry: Prospect and problem. Journal of Food, Agriculture and Environment. 1313. 143-148.

An Investor’s Guide to Palm Oil: https://www.toptal.com/finance/market-research-analysts/palm-oil-investing

Crude Palm Oil Mill Process: https://andythoncianus.wixsite.com/andythoncianus/single-post/2018/03/11/Crude-Palm-Oil-Mill-Process

FCPO Product Brochure: https://www.bursamalaysia.com/sites/5bb54be15f36ca0af339077a/assets/5d5e64575b711a6fbc2aa31f/FCPO_Product_Brochure_200219.pdf

Indonesia: “Plasma Obligation” For Oil Palm Plantation Business Established Prior To The Issuance Of Regulation Of The Indonesian Minister Of Agriculture No.26/2007: http://www.mondaq.com/x/467128/Inward+Foreign+Investment/Plasma+Obligation+For+Oil+Palm+Plantation+Business+Established+Prior+To+The+Issuance+Of+Regulation+Of+The+Indonesian+Minister+Of+Agriculture+No262007

Plasma Scheme: https://www.bumitama-agri.com/page/layout/24/23/plasma-scheme

Riverina: https://www.riverina.com.au/products/palm-kernel-meal/

The Optimal Age of Oil Palm Replanting: http://palmoilis.mpob.gov.my/publications/OPIEJ/opiejv2n1-2.pdf

Building a Diversified Portfolio – A Defensive Strategy

By Huang Zixun

It is often said that the biggest fear that keeps people from investing is the fear of losing their hard-earned money. This is understandable as the certainty of cold, hard cash in hand definitely beats the uncertainty of investments. Furthermore, horror stories of other investors’ savings wiped out by events such as Noble Group’s share price collapse and Hyflux’s insolvency have certainly not helped matters.

In view of that, diversification acts as a defensive investment strategy to lessen losses. So what exactly is diversification? In layman terms, it is all about “not putting your eggs in one basket”. This means that investors actively allocate their capital in a manner that reduces any exposure to any one particular asset or industry. Hence, even though no asset is truly risk-free, diversification mitigates risk across the entire portfolio.

Types of Risks, Asset Allocation and Diversification

Before going into diversification proper, it would be best to give a general overview of the two main types of risks associated with investments. This would clear up some misconceptions associated with asset allocation, diversification and the risks that they reduce.

1. Unsystematic Risk

This form of risk commonly occurs within a specific company or industry. While this form of risk typically occurs due to internal factors within the organisation, industry-wide events can negatively impact share prices by exposing business risk.

Graph of Keppel Corp’s share price in relation to oil prices. Source: BP Wealth Learning Centre

Graph of Keppel Corp’s share price in relation to oil prices. Source: BP Wealth Learning Centre

To illustrate this, as seen in the graph above, Keppel Corp’s share value was more than halved between 2014-2015. This was due to a crash in oil prices, and the same was also true across the offshore and marine industry. If prior to 2014, an investor’s portfolio comprised only of stocks from that industry, the portfolio’s value would have suffered a massive decline.

However, suppose the portfolio had increased diversification. An example would be concurrent holdings in the airline or transportation industry which by and large, benefitted from lower oil prices due to cost reductions. Gains in those areas would have reduced any losses incurred from holdings in merely the offshore and marine industry.

Risk and Diversification. Source: ValueWalk

Risk and Diversification. Source: ValueWalk

2. Systematic Risk

Also known as market risk, such risks are commonly associated with macro factors, typically caused by changes occurring across the entire market such as interest rate changes or economic recessions. It is highly unpredictable and impossible to avoid as the entire market is affected by these broad events. Systematic risk is not diversifiable as the value of financial instruments across the market are affected. This means that simply increasing the types of shares held, if your portfolio is already well diversified, will not aid in reducing systematic risk.

With this in mind, a common method used to reduce systematic risk is through careful asset allocation. Contrary to popular belief, asset allocation is different from diversification. An investor whose portfolio consists entirely of 50 equities across multiple industries has good diversification. However, that is an example of poor asset allocation, and the value of that portfolio would plummet in the event of a stock market crash such as the great recession in 2008, which is an example of systematic risk.

Thus, a balanced asset allocation with the inclusion of components such as fixed income and interim cash would act as a hedge against such risks. In order to effectively mitigate risks, asset allocation should be utilised in conjunction with diversification.

Cost-effective Methods for Diversification

One of the main drawbacks of diversification is the potential high cost involved. Not everyone will have the capital to purchase more than 20 different equities. Thus, here are 3 cost-effective components to consider adding to your portfolio to improve asset allocation and diversification.

1. Exchange Traded Funds (ETFs)

ETFs are a form of investment funds that hold a group of assets such as stocks or bonds, and are listed and traded on the stock exchange. One prominent example in the Singapore market is the Nikko AM Singapore STI ETF that tracks all 30 companies in the Straits Times Index which has generated a 9.54% annualised return since its inception in 2009. Other than stocks, other prominent ETFs in the SIngapore market include the Lion Philip S-REIT ETF that tracks Real Estate Investment Trusts (REITs) in Singapore, as well as the ABF Singapore Bond Index Fund that holds investment-grade bonds.

Among retail investors, ETFs are one of the most popular forms of investments nowadays, for a good reason. Primarily, ETFs provide a simple and low cost way to diversify a portfolio by exposing investors to a range of asset classes across multiple industries. Furthermore, ETFs have much lower management fees of less than 1% as compared to unit trusts or mutual funds that have management fees of up to 5%.

2. Fixed Income

Bonds have traditionally been overlooked by many retail investors (at least for investment-grade bonds) because their potential returns are not as high as equities due to the lower risk involved. However, volatility in the global markets have led to many investors diversifying their equity-heavy portfolio to guard against a bear market. In fact, during the 2008 recession, while US equities fell by 45%, the treasury bond market benefited, as 10-year US treasury bond yields fell from 3.91% to 2.89. This meant that treasury bond investors made a profit, and investors who held a mixture of bonds and equities would have suffered a much smaller loss than those who had a pure-equity portfolio.

In the Singapore context, Singapore Savings Bonds have been seen by retail investors in recent years as a viable fixed income asset backed by the Singapore government. However, over the past year, average yields have been steadily falling. Alternatively, bond funds such as the ABF Singapore Bond Index Fund, as well as the Nikko AM SGD Investment Grade Corporate Bond ETF, are also effective methods of diversification as those funds invest in a basket of bonds.

3. Robo-advisors

A relatively new development on the market, robo-advisors refer to online investment platforms that perform investment management with minimal human intervention. Their differentiating factor from other funds would be their lower expense ratio as compared to traditional fund managers due to the fewer man-hours needed to manage the fund. Usage of such services are ideal for investors who are more hands-off and are looking for a more simplified and convenient investing process. Custom portfolio asset allocation can also be structured as they weigh expected returns against risk appetite. Furthermore, diversification can be achieved as robo-advisors would invest in a mix of equities and fixed income assets across regional and even global markets. Prominent robo-advisors based in Singapore include DBS digiPortfolio and StashAway.

To Conclude

Overall, diversification as an investment strategy is a viable method for risk reduction. However, one must bear in mind some of the drawbacks as well. The basic rule of investments still apply: with lower risks, comes lower returns. As diversification reduces large potential losses by averaging out risk and volatility, it equally reduces large potential gains. Thus, if you have a high risk appetite and the financial know-how, a concentration strategy may be a better fit for you.

Furthermore, it is worth reiterating that pure diversification will not protect against market-wide systematic risk, because in recessions, the entire market will go down regardless of industry. To mitigate such risks, careful asset allocation has to be implemented in tandem with diversification. For best results, due diligence has to be done before making any form of investment to ensure sufficient knowledge of the risk level and how it would value-add to your portfolio.

References:

Why diversification matters – https://www.fidelity.com/learning-center/investment-products/mutual-funds/diversification

Why it’s important to diversify your investments and how to go about doing it – https://www.todayonline.com/singapore/why-its-important-diversify-your-investments-and-how-go-about-doing-it

Keppel share price with oil crash – https://bpwlc.com.sg/keppel-corp-sembcorp-marine/

Unsystematic vs Systematic Risk – https://www.blackwellglobal.com/unsystematic-vs-systematic-risk/

Managing (systematic) risk – http://www.sr-sv.com/managing-risk/

Risk & Diversification Graph – https://www.valuewalk.com/2016/03/warren-buffett-thinks-risk-2/

Art of diversification – https://dollarsandsense.sg/the-art-of-diversification-what-you-should-know-if-you-want-to-diversify-your-investment-portfolio-effectively/

ETFs Overview Singapore – https://blog.moneysmart.sg/invest/index-fund-etf-singapore/

Nikko AM STI ETF – https://www.nikkoam.com.sg/etf/sti

Bonds in a bear market – https://www.thebalance.com/what-happens-to-bonds-in-a-stock-bear-market-417053

Robo-advisors for diversification – https://www.thebalance.com/what-is-a-robo-advisor-and-how-do-they-work-4097134

Why robo-advisors – https://www.drwealth.com/why-use-robo-advisors-at-all/