It is time to harbour some doubts about the STI ETF.

It is now about the right time to start casting doubt on the STI ETF. At this time, a lot of my fellow bloggers have started to integrate the STI ETF into their primary strategies and it would be useful to consider counter-arguments against using the STI ETF as a primary tool to extract market returns from the SGX counters.

Before I start, active managers have waged a media campaign against ETFs for quite a while now and you can easily find such articles all over the web. When I criticise ETF strategies, I am not suggesting that we regress and begin looking at expensive active management funds again. No sane investor should tolerate high management expenses only to have unit trust managers try to replicate the STI ETF to minimise their career risks.

a) If everyone invests in the STI ETF, the market will fail.

The primary argument against ETFs is that when everyone invests in it to the exclusion of everything else, the market will fail because you can't reward well run companies and punish those which are run badly. This argument is relatively weak because there is currently no risk of everyone investing in ETFs. Even if the risk were to ever happen, we would likely see many smart beta ETFs in the market to ensure that this would never come to pass.

The question has always been whether your performance would be inferior as adoption of the STI ETF ramps up over the next few years.

b) Equal weighting the STI index components leads to better performance.

The STI index is biased towards stocks with a larger capitalisation and the banking sector. Right now the banking sector is dealing with the bad loans from the O&M sector.

In the last event by BigScribe, Teh Hooi Ling reports an annual performance of around 3.5% over 10 years for the STI. I backtested a portfolio that uses equal weights in the STI index and I can report a 1-2% improvement over the STI ETF.

This would have been a great argument to buy STI components in equal proportions directly until I figured out that the minimum size of an investment in Jardine Matheson Holdings is $6,520 USD. The minimum portfolio size you will need to craft an equal weighted STI portfolio is slightly less than $300,000 SGD.

c) Using a sane retail investment strategy can result in superior performance quite easily.

So far in all my backtests, it does not seem to difficult to beat the STI index. Choosing REITS that yield between 6-8% can result in double the performance, so can simply looking out for stocks with a dividend yield above 7%. It also seems that Factor investing, taught my many credible providers like Dr Wealth, can consistently outperform the markets if the horizon is long enough.

Of course sane is not a very objective measure.

For me, sane means that it should begin with a hypothesis about over performance. For example, the idea that cheap stocks outperform, with cheap being  a low P/B ratio or high yields. Then this needs to be backtested. As an added measure, the strategy should remain robust when employed against data from a different market. As a bonus, you should also read up on analysts who specialise in bottom up investing to understand the state of the companies you are investing in.

Overall, the STI ETF remains a much welcomed innovation in the markets. Combined with a Asian Bond ETF, it allows most retail investors to basically put in a market position and then tune out of monitoring the markets. Furthermore, a lot of of financial bloggers welcome this instrument as we conveniently have an answer to any novice who wants to know what is the best way to invest their first $10,000.

But for intermediate investors who can afford more time on investing their money, it's time to start thinking about how we can craft a portfolio which goes beyond the STI ETF in effectiveness.

If we do a good job at that, we might even save the STI ETF strategy from it's own success.