Investors around the world are turning to exchange traded funds (ETFs), pooled investments that give you the same return as an index. We explain why ETFs are moving in on the space occupied by unit trust funds and what you should know before you invest.
On January 29, 1993, State Street Global Advisers, in partnership with the American Stock Exchange, launched the first exchange traded fund (ETF) on the New York Stock Exchange (NYSE) under the code SPDR 500. More commonly known as a spyder (pronounced spider), the ETF tracks the performance of the Standard & Poor's (S&P) 500 index.
The S&P 500, published since 1957, is a free floating, weighted market-cap index of the prices of the 500 actively traded, large-cap common stocks on the two largest American stock markets, the NYSE and the Nasdaq.
On November 30, 2000, a newly formed company, Satrix, with the JSE as an initial shareholder, launched the first ETF to list in South Africa. The Satrix 40 ETF tracks the FTSE/JSE Top 40 index, which follows the collective fortunes of the 40 largest listed companies in this country. By July last year, more than 2 000 ETFs were listed on stock exchanges in 42 countries, with more than US$862 billion managed on behalf of investors. In South Africa, 24 ETFs had listed on the JSE by December 1, 2009, with R27.771 billion in assets under management.
Mike Brown, the chief executive of the recently launched ETF trading platform etfSA.co.za - The Home of Exchange Traded Funds, says the main reasons for the growth in ETFs are:
- Most asset managers of active funds do not beat their benchmark indices over the long term. Very few, if any, active asset managers have matched the average annual growth of the FTSE/JSE All Share index (Alsi) of 19.2 percent over the past 10 years and 21.1 percent over the past 30 years.
- The performance of ETFs is not undermined by the high costs of active management. Costs significantly detract from returns over time.
- ETFs are perfectly placed to benefit investors - from do-it-yourself investors to institutional investors, such as retirement funds - who have realised the merits of low-cost, passive investing over the long term.
Worldwide, there has been a tremendous growth in the popularity of ETFs compared with other collective investments, such as unit trust funds and life assurance investment portfolios.
But be warned: ETFs do have their drawbacks, as well as many of the risks of other collective investments. As with any investment, you should understand the advantages and disadvantages of ETFs. Here are 10 things you should know:
ETFs are passively managed investments that are a hybrid of collective investment schemes (CISs) and listed investment companies that invest in other companies.
All ETFs are listed on a stock exchange.
You can buy units (shares) in an ETF with either a lump sum or a recurring monthly premium. An ETF may or may not be registered as a CIS, which is a structure, governed by legislation, that enables investors to buy units in a pooled portfolio.
To qualify as a CIS in terms of the Collective Investment Schemes Control Act (Cisca), an ETF may invest only in securities, such as equities and bonds, that are listed on a securities exchange, such as the JSE. This means that an ETF that tracks, say, a commodity, such as gold, or that actually owns bullion, such as Absa Capital's NewGold ETF, cannot register as a CIS in terms of Cisca.
The major similarities and differences between an ETF and a unit trust fund are:
- ETFs and unit trust funds are pooled investments: the money of thousands of investors is combined to purchase a selection of securities in a market or a market sector. You, the investor, can derive all the advantages of a pooled investment from either an ETF or a unit trust fund.
Most ordinary investors cannot afford to buy all the individual securities that would be required to create a properly diversified portfolio. It is the pooled nature of ETFs and unit trust funds that makes them attractive to individual investors.
- Unit trust funds must be registered with the Financial Services Board (FSB) as CISs in terms of Cisca. ETFs can choose whether or not to be registered as CISs. If an ETF is not registered as a CIS, it is subject to the Securities Services Act (previously the Stock Exchanges Control Act).
ETFs that are subject to Cisca are also subject to the Securities Services Act.
- ETFs allow for more diversification, as they provide investment opportunities, particularly in commodities, that are not available through unit trust funds. Very few individuals can invest in commodities because of the huge sums required. Although unit trusts can invest in listed companies whose business operations involve commodities, they cannot invest in the commodities themselves. ETFs can invest in anything that has a price that can be tracked.
- You can own a fraction of a unit trust fund, but you cannot own a fraction of an ETF, because you are in effect buying shares listed on an exchange. You cannot buy a part of a share.
- A unit trust fund may be managed actively by an army of well-paid (some would say excessively paid) fund managers and analysts. An ETF is always managed passively; it tracks a predetermined index or a price. Although you can invest in a unit trust that tracks an index, and may even have lower tracking errors than an ETF, the fund may not reflect the index accurately (see point 7).
- ETFs are traded like shares, so you can buy or sell an ETF at a given quoted price throughout the trading day, whereas you must buy or sell a unit trust at its net asset value at the end of the trading day. You know the price at which you will buy or sell an ETF, but you do not know the exact price at which you will buy or sell a unit trust fund.
ETFs are similar to investment companies listed on stock exchanges. But, just as there are differences between ETFs and unit trust, there are also significant differences between investment companies and ETFs.
These differences include:
- Investment companies invest in listed and unlisted companies. Examples of investment companies are:
* Anglo American, which has a bias towards mining but also has investments in sectors such as property and financial services;
* Barloworld, which has an industrial bias;
* Remgro, which has a financial services bias but is also invested in mining, packaging, health services and food; * Richemont, which has strong links to Remgro, owns companies internationally that provide luxury and fashion goods;
* RMB, which has a financial services bias, controls companies such as major bank First National and life assurance company Momentum; and
* Tongaat, which has investments in aluminium, bricks, property and sugar.
An investment company can hold a share in any listed or unlisted company in any proportion the investment company's decision-makers desire.
ETFs, on the other hand, involve little direct intervention by asset managers. The only intervention occurs as a result of unusual events such as share splits, company takeovers or an alteration of an index. Investments made by ETFs are predetermined, because they track mainly an index or a price. All the early ETFs were linked directly to the performance of well-known indices, such as the S&P 500 or the FTSE/JSE Top 40.
The shares held by an ETF will reflect the composition of its selected index. In other words, unlike an investment company, an ETF portfolio manager does not have the discretion to choose the investments.
- Investment companies trade mainly at a discount to the total value of their underlying holdings. ETFs tend to trade at, or very close to, the value of their underlying investments. The reason is that a holder of an ETF can demand the actual shares that underlie the investment. This means that if a gap opened between the value of the ETF and the underlying shares, investors would immediately demand the underlying shares. So although technically you can offer to buy or sell an ETF, as you can any other listed security, if someone took advantage of your offer to set a different price, the difference would close immediately, because shareholders in the ETF can demand the underlying shares. A shareholder in an investment company cannot demand the shares of the underlying investments.
The range of ETFs is broad, particularly internationally. There are ETFs that track stock markets, property markets, bond markets, money markets, currencies and commodities.
An ETF may track something as simple as an index (such as the Alsi), a subset of an index (such as the Top 40 or the FTSE/JSE Industrial index) or benchmarks that are adjusted and weighted by things such as dividend yields (such as the Satrix Divi). ETFs can track well-known indices or something as obscure as wool prices in New Zealand.
Most early ETFs were what can be termed vanilla (basic) ETFs that tracked established, well-known indices. Increasingly, ETFs are being brought to market with a range of bells and whistles. For example, the Satrix Rafi ETF and the Plexus/Absa Capital eRafi ETFs aim to provide investors with enhanced performance by applying mathematical formulas to the available data (see Higher returns without tears).
Vladimir Nedeljkovic, who is in charge of ETFs and index products at Absa Capital, says vanilla ETFs that track a market-cap index (see What the terms mean below) can invest too much of their money in relatively overpriced stock and too little in relatively underpriced stock, which is contrary to sound investment principles. Nedeljkovic says ETFs can minimise this inefficiency by taking into account other factors on a predetermined basis.
Rafi stands for Research Affiliates Fundamental Index; the e in eRafi is for enhanced. The Rafi and eRafi indices were pioneered by California-based Research Affiliates.
There are three main differences between the Satrix Rafi 40 ETF and the Plexus/Absa Capital eRafi ETFs:
- The eRafi ETFs use six underlying factors to calculate the index, against the four used by the Rafi ETF. The methodologies of both the eRafi and Rafi weight shares in the selected indices according to company sales, cash flow, the value of the business and dividends. But the eRafi has two additional filters: the quality of profits and financial distress risk. All this data is available publicly and is simply fed into a computer program on an ongoing basis.
- The Satrix Rafi 40 ETF is a total return fund that automatically reinvests the dividend income of the companies that constitute the index, providing immediate capital growth on income. The total return characteristic of the Satrix Rafi means that the performance of the Absa/Plexus eRafi and the Satrix Rafi is similar.
- The eRafi ETFs charge a performance fee, whereas the Satrix Rafi ETF does not. As a result, when the performance of the eRafi Overall ETF and the Rafi ETF are compared over their short histories, the Rafi ETF has out-performed the eRafi ETF after costs.
However, historical back-modelling by Research Affiliates shows that over 10 years the eRafi would have provided an average total return after costs of 20.46 percent, whereas the Rafi would have provided an annual average total return of 19.5 percent. Both funds would have out-performed the total annual return of 16.78 percent provided by the Alsi. A vanilla ETF, which simply tracked the Alsi, would have slightly under-performed the Alsi, and its performance would have been well below that of both enhanced ETFs.
Nedeljkovic says that based on a long-term historical study, Rafi methodology out-performs the broad market by 1.9 percent a year in the United States, 2.7 percent a year in 23 of the 30 Organisation for Economic Co-operation and Development (OECD) countries surveyed, and produces significantly higher returns than emerging markets (in South Africa, for example, between five and seven percent a year, depending on the market sector).
Generally, looking at the 23 OECD country study, Rafi methodologies would on average under-perform vanilla market-cap indices only during strong bull markets (average annual returns of 30 percent-plus in the benchmark index in developed equity markets).
We believe that this enhanced investment approach represents a step forward for ETFs, as it addresses the problems with market-cap weighted indexation without sacrificing the advantages of indexation - namely, convenience, transparency and cost-effectiveness - compared with the alternatives, Nedeljkovic says.
The range of ETFs is limitless. Anything, whether it is a single commodity, such as gold, or a group of entities, such as stock market indices, that has a price that can be tracked can be made available as an ETF. On foreign stock exchanges, there are even ETFs that allow investors to profit from market downturns by shorting the indices.
There is an animal available on some foreign exchanges called an Ultra ETF that uses gearing to increase its exposure to an index. In simple terms, an Ultra ETF could enable you to receive double the performance of the index, but if the index goes south, you could double your losses.
One consequence of the wide range of choice is that ETFs have various risk profiles. The main risk is volatility (the propensity for an investment to go up or down in value as markets rise or fall). For example, an Ultra ETF that tracks a currency will have far more risk than an ETF that tracks a money market.
Performance rating company PlexCrown Fund Ratings and etfSA have combined forces to create a survey that measures the risk (including volatility risk) of the various local index-tracking products (ETFs and unit trust funds) and that applies a risk-rating to each product. This will help investors to measure the risk taken with the various types of ETFs.
The PlexCrown/etfSA ETF survey, which will be published quarterly, will be available on the etfSA website ( www.etfsa.co.za) and the PlexCrown website ( www.plexcrown.co.za). For investors who want more information, or an analysis of a specific ETF or all ETF products, PlexCrown offers a comprehensive risk analysis, fund profile and ratings service. You can contact PlexCrown through its website.
The PlexCrown/etfSA ETF survey also measures and ranks the tracking errors of the products relative to their indices. The tracking error measures the extent to which the products deliver the total return of the indices they track.
As with any other investment portfolio, the more diverse your ETF portfolio, the more you will reduce the volatility. A properly diversified portfolio should hold all the main asset classes (equities, bonds, property and cash) and market sectors, both locally and abroad (see point 9).
ETFs in South Africa are available in all the main assets classes except cash (money market funds), allowing you to compile a well-diversified investment portfolio using ETFs. Brown says ETFs that track money markets should become available soon.
Nedeljkovic says he does not expect an explosion in domestic ETFs as has been the case with unit trust funds. He says the limited size of the South African securities market and the liquidity (availability) of equities and bonds will put a brake on the expansion of ETFs. I would be surprised if the number of listed ETFs in our market ever exceeds 50.
The opportunity, as we see it, lies not in increasing the number of ETFs but in creating products that satisfy the needs of carefully identified market segments or investor needs, and in developing and implementing an efficient distribution (sales) mechanism for existing products, Nedeljkovic says.
Costs are one of the main factors driving the ever-growing popularity of ETFs over unit trust funds, particularly actively managed unit trusts, the costs of which have been on an upward spiral.
ETFs generally have lower costs than other investments, because they are not actively managed and their underlying share portfolios are not traded regularly. ETFs normally have lower marketing, distribution and administration expenses. In a nutshell: ETFs do not involve rocket science or armies of expensive analysts, and this results in significantly reduced costs. Unit trust funds, which at one stage were limited to charging asset management fees of one percent a year, are creating cost structures that are as complex and expensive as those that gave life assurance investment products a bad name.
Last year, independent actuary Rob Rusconi, who blew the whistle on the high cost of life assurance retirement annuity (RA) fund products, calculated that for every one percentage point you save in costs, you will add 19 percent to your final maturity value after 40 years (namely at retirement).
At the 2007 Sanlam retirement survey seminar, David McCarthy of the Tanaka Business School at Imperial College in London said that a fee of 1.5 percent will reduce your final benefit by as much as 30 percent.
Rusconi has also looked at the costs of ETFs. He found that all ETFs can be expected to lag the index, just as actively managed funds do, but we expect this lag, on average, to be smaller and more stable. The reasons ETFs lag their indices include:
- The cost of rebalancing the portfolio. The portions of the constituents of the index will change relative to the basket of shares because of various actions taken by companies, such as share splits and rights issues. This mismatch contributes to the lag, while rebalancing the portfolio to align the ETF with the index results in transaction costs, such as stockbroker fees and taxes.
- The cost of investors buying or selling shares in the ETF.
- ETFs are not allowed to pay out or reinvest dividends on the date they are paid by a company. As part of their securities exchange listing requirements, ETFs are limited to paying or reinvesting dividends quarterly. The dividends are invested in interest-earning accounts. This means that when interest rates are low, these dividends will retard performance.
- A small portion of assets must be held in cash to facilitate the cash flows that are required for the purchase and sale of ETF shares or units, while no borrowing is permitted to cover cash flow shortfalls.
Part of the costs is recovered by scrip-lending operations in the derivative markets, which help reduce the lag between an ETF and its index (see What you should know about scrip lending). The average lag between the performance of the Satrix 40 and its index is 0.37 percent a year, and the average lag for all other index-trackers (unit trusts and ETFs) is 1.64 percent.
Normally, the administration fees for ETFs are seldom above one percent a year.
Costs include brokerage (the cost of buying or selling shares) when the index changes and when you buy the ETF shares.
The annual administration fees for most ETFs are on a sliding scale, reducing substantially when you invest large amounts of money. The sliding scale can start at, say, 80 basis points a year (0.8 percent) for investments under R100 000 and reduce to 45 basis points a year for amounts above R3 million.
Costs will also vary depending on how you purchase your units. You can purchase units directly from either a product provider or the etfSA platform at the same cost; through a financial adviser, who will charge an advice fee; or through a stockbroker, in which case brokerage and settlement charges will have to be taken into account.
However, you must be aware that some ETFs, particularly those that are sold offshore, have high charges. Furthermore, some ETFs, such as the eRafi funds, have performance fees, which add to the costs.
The performance fee of 20 percent for the eRafi ETFs is based on the out-performance of selected benchmarks.
The overall benchmark for the eRafi ETFs is the Alsi.
However, they also have a high water mark, and once that benchmark has been achieved, it is not reduced as a result of market downturns. The performance fee can be charged again only once the benchmark has been breached.
Plexus and Absa Capital argue that the performance fee charged for the eRafi ETFs is justified, because you are paying for the intellectual capital to develop the methodology that is used to provide the enhanced performance.
Apart from costs, the main reason to own an ETF is that you will receive the market average, and your returns will not be subject to the volatility of actively managed portfolios.
ETFs are managed passively, even when, as with the eRafi and Rafi ETFs, they are enhanced by following a mathematically based methodology, commonly known as quants. No ETF investment manager makes a decision at his or her own discretion to buy or sell an underlying investment.
This does not mean that ETFs are never subject to active management. Overseas, it is possible to invest in what are called actively managed ETFs, which are made up of a basket of ETFs of different asset classes and market sectors. The portfolio manager buys and sells the underlying funds or trades the ETFs on the derivatives market in an attempt to enhance profits, based on a view of how an asset class or a market sector will perform.
ETFs are ideal instruments for speculators who want to take advantage of market movements as opposed to the prices of the underlying instruments.
But in general, tracker investments, or passive, investments, aim to provide the market average. In other words, they aim to provide what is called beta: the returns provided by the market. For example, if an entire stock market, or a sector of a market, goes up by 10 percent, your investments increase in value accordingly. The return did not require any skill by an asset manager.
Alpha describes the extra returns you may receive as a result of the skills of an asset manager. So, if you receive a total return of 12 percent after the market has gone up by 10 percent (the beta), the additional two percent is the alpha.
But all too often, particularly after costs, alpha is not the alpha and omega (the beginning and the end) of investing - alpha can also be negative, reducing beta.
Products that seek to provide beta alone are called tracker funds, or passive investments, because they merely track the performance of an index. In other words, they provide the aggregate performance of all active investors.
Research, both here and abroad, shows repeatedly that very few active asset managers out-perform their benchmarks (often an index) over time. In fact, most active managers consistently under-perform, and the under-performance is exacerbated by the higher costs of active management. These costs are due mainly to the large teams of analysts and portfolio managers, who receive extraordinary pay and bonuses.
If you look at any unit trust performance table, you will see a significant divergence in the performance of active managers, particularly in the short term. However, over the long term, the performance tends to converge, indicating that active managers out-perform and under-perform consistently.
The problem for many investors is how to spot the asset manager who will provide out-performance consistently. There are a few who do, but most do not. ETFs are passively managed and provide the average return of the market, without the risk of under- or out-performing the market.
The passive-versus-active debate has been raging for a number of years, with active managers doing everything they can to pooh-pooh passive management. Increasingly, however, there is agreement that both active and passive investing have their advantages, with a blend of the two approaches offering the best solution. Financial market researchers are suggesting that investors should have a core of passively managed tracker funds and a satellite of actively managed specialist funds.
Research undertaken in 2007 by Daniel Wessels, of advisory firm Martin Eksteen Jordaan Wessels, shows that the longer your investment term, the higher your returns from index-linked investments.
But, Wessels says, actively managed investments also have a role to play in your portfolio. He says index investing is a sound long-term strategy, and index investments should make up at least 30 percent of your equity portfolio.
Wessels's research, which was based on an analysis of South African general equity unit trust funds, was aimed initially at establishing whether following an active or a passive investment strategy provided better returns.
Wessels has concluded that:
- Based on historical performance, you would have received the highest reward per unit of risk if you had integrated both active management and passive management.
- It would not have been prudent to have placed your faith in either an active or a passive strategy.
- Index investing in South Africa differs from that in developed countries, because the JSE has a higher proportion of mining and resources shares. Active managers tend to underweight their portfolios with resources stocks, so when the resources sector is roaring ahead, a fund that tracks the Alsi is more likely to out-perform actively managed funds.
- Once the upfront costs you pay to invest in active funds are excluded, active funds, on average, out-perform the benchmark index. However, when the costs of active investing are included, there is a significant impact on performance, especially over shorter periods.
- On a risk-adjusted basis, the index benchmark fared better than the average actively managed fund.
- Over time, index investing and active management repeatedly replaced each another as the dominant investment strategy.
When combining both strategies in various combinations over different investment periods, it was found that the highest reward-to-risk ratio was attained by increasing index investing relative to active investing, with an increase in the investment horizon. Simply put, the longer your investment term, the more index investing should be followed, Wessels says.
He says it can be argued that over the long run it is difficult for active management to beat the market (the index) consistently.
Therefore, investment strategies should be aligned with one's faith in the efficiency of markets over time and should not be overly influenced by the short-term performance records of active managers.
Wessels says various international studies have shown that index investing out-performs the average actively managed fund on average over the long term, and this has led to the widespread adoption of the strategy. In the developed world, between 20 and 30 percent of equity funds (both institutional and private) are invested in index funds, and these index funds are growing fast.
Johan Pyper, the head of research at Plexus Asset Management, says supporters of passive investing argue that markets are efficient and shares are always priced correctly, and the main reason active managers under-perform is the higher cost.
Pyper says in fact there should now be a three-way active/passive debate. He says with the development of clever indices, it has been proved that markets are not that efficient.
The types of funds now involved in the debate are:
- Traditional index-trackers, constructed according to the market capitalisation of the underlying investments. If the total value of the underlying components rises, so does the index.
- The new ETFs that enhance performance using fundamental factors, such as taking into account, on the basis of a predetermined methodology, the profits and sales of the underlying companies in the index.
- Actively managed funds, which seek to out-perform benchmark indices.
Pyper says Plexus's research has shown that the return profile of enhanced tracker funds tends to be similar to that of actively managed portfolios.
He says the research also shows that passively managed funds generally out-perform actively managed funds in bull markets but under-perform them in bear markets. The reason is that active managers can include defensive shares (companies that are more likely to maintain their profits in market downturns) in their portfolios and have a greater exposure to cash during market downturns. But cash, which unit trust funds are obliged to hold, can drag down the performance of actively managed funds when markets are rising.
Pyper says it thus makes little sense to argue about which management style is better.
It is more meaningful to construct an investment portfolio that comprises a core of good active managers, including an enhanced index-tracker, to reduce costs, and a traditional index-tracker to share in the strong returns it delivers in bull markets. When investors become concerned about markets and want to position their portfolio defensively, they should switch from traditional index-trackers to good active managers and funds that track fundamental indices.
Most local ETFs give you double protection. The reason is that most ETFs are registered CISs in terms of Cisca. And because all ETFs are listed on a stock exchange, they are also regulated by the JSE in terms of the Securities Services Act. The main effect of this legislative environment is that there are very strict controls about how your investment is handled and who holds what.
For example, in terms of Cisca, your investment must be held by a custodian and not by the asset manager. In terms of the Securities Services Act, your ETF shares must be recorded in your name on the Strate electronic register.
However, these controls do not protect ETF investors from market volatility. As with any other investment, you still need to ensure that you make the correct investment choices, either on your own or after having obtained advice if you are not sure what you are doing.
Both Cisca and the Securities Services Act are administered by the FSB.
If your ETF is listed as a CIS, what is called the conduit principle applies. This means that you will pay capital gains tax (CGT) on any profit you receive on selling the security. Any interest earnings are taxed as income (income tax) in the year you receive the payment (whether or not you reinvest the money); and the same will apply when dividends tax is introduced.
You are not taxed on any of the trades that are made to keep the ETF in line with an index. The same principle applies to all ETF portfolios, irrespective of whether or not they are structured as CIS portfolios.
However, be warned that if the South African Revenue Service considers you to be a trader, because you buy and sell on a regular basis, you could be subject to more punitive income tax, rather than CGT, on your profits.
ETFs go head to head with unit trusts for a number of reasons, even when the unit trust is also an index-tracker. Apart from the active/passive debate, the reasons ETFs are moving in on the space occupied by unit trusts are:
- ETFs have lower costs than most unit trust funds, which are increasingly burdened with complex fee structures, particularly performance fees. However, the costs of some unit trust index-trackers are competitive compared with ETFs.
- You know the price you will pay or receive when you buy or sell your ETF units. The price for your unit trust is set at the end of the trading day, leaving you pretty much in the dark about what you will pay or receive. While this may not affect long-term investors significantly, it can make a considerable difference to anyone who trades regularly.
- Unit trust index-trackers are limited by the requirement that they may not hold more than a certain percentage of any one underlying investment. The result is that a passive unit trust fund will not necessarily reflect the index precisely.
- An ETF does not have cash drag. A unit trust must hold a minimum of five percent of its assets under management in cash to pay for redemptions. Over the medium to long term, cash provides the lowest return of all asset classes, so the cash holdings drag down the performance of a unit trust fund.
- You can always know the composition of an ETF's portfolio: you just need to check on the parts that constitute the index. This information is publicly available. With a unit trust fund, you are told only about the top holdings every quarter.
The see-through of the underlying investments of ETFs enables serious investors to ensure that their portfolios are properly diversified.
If you attempt to construct a diversified unit trust fund of funds, you can never be sure if you are overweight in a particular share or sector, as the portfolio manager of a unit trust fund could make significant changes during the quarter, exposing you to risks you may wish to avoid.
- ETFs are easily accessible to do-it-yourself individual investors. Many unit trust funds require you to invest through a financial adviser (see point 8).
- ETFs enable you to access all the markets and market sectors that are available to unit trust fund investors, as well as those that are not, particularly commodities. Investors in unit trust funds are limited to investing in companies that produce or trade in commodities.
- ETFs can be traded in all the main derivative markets, such as the options and futures markets.
- You can short sell an ETF, because it is a listed security, but you cannot short sell a unit trust fund investment. In simple terms, short selling is selling a share you do not own to buy it at a lower price. The reasons for short selling are:
* To take advantage of falling markets. You sell a share you do not own (but borrow) at a high price today to use the proceeds to buy back the share at a lower price in the future to make a profit.
* To hedge (protect against falling markets).
South Africa has been a latecomer to investor-friendly ETFs. The three main reasons for the slow growth of the local ETF market are:
- A financial services industry that historically has done much to block the development of low-cost, simply structured investment products, which the industry sees as a threat to its complex, high-cost, high-profit products.
- ETFs pay lower, negotiated commissions to financial advisers, particularly when compared with the fixed, excessive and perverse commissions paid by the life assurance industry on its investments.
- ETFs were initially not offered on many linked-investment service provider (Lisp) platforms, which in effect are controlled mainly by the established financial services companies. The consequence of this was that ETFs were not offered as underlying investment choices with products where most South Africans have their accumulated wealth: retirement products, particularly RAs and investment-linked living annuities (Illas).
Until last year, if you wanted to invest in ETFs, you had to find out about them on your own and invest in them on your own.
There are three ways to invest in ETFs. These are:
- Directly with an ETF company. All local ETF product providers offer online investment facilities that enable you to make a lump sum investment and/or regular investments using a debit order.
You can invest in ETFs with a lump sum as low as R1 000 or with a recurring debit order that starts from R300 a month.
- Through a stockbroker. ETFs are listed shares, so they can be traded as such. However, you will have to pay brokerage costs, which can vary greatly; online brokers are generally the cheapest. Minimum charges also apply, so it is probably better to use other channels if you are investing smaller amounts.
- Via an administration platform. Recently, etfSA launched an internet-based investment and administration service platform that allows you to make lump sum or regular debit order investments, or to switch between funds. etfSA provides the full range of local ETFs at no additional cost: you pay the same as you would if you accessed the ETFs directly from the pro-duct provider.
The etfSA platform ( www.etfsa.co.za),which provides extensive information about all the ETFs available in South Africa, including quarterly performance and cost surveys, is operated via itransact, an investment and reporting platform owned and run by Automated Outsourcing Services.
Some Lisp administration platforms allow you to invest in a limited number of ETFs, and Lisps are under increasing pressure from investors to offer the full range of ETFs on their platforms.
The advantage of the etfSA platform over Lisps is the high cost of the Lisps, which can charge as much as two percent of your assets every year, effectively undermining the cost advantage of ETFs.
The principles of building an ETF portfolio are much the same as those that apply to any other investment portfolio. The principles you need to take into account are:
- Diversification. You should invest across asset classes, markets and market segments, both locally and offshore. Diversification reduces risk, as the performances of asset classes often do not correlate. In other words, while one asset class or market sector is faring badly, others could be performing well.
- Your risk profile. The diversification of your portfolio will depend on your needs. If you require capital growth, your portfolio should be weighted heavily towards growth assets, such as equity ETFs. If you require an income, you should be looking to money market ETFs (when they become available), bond ETFs, property ETFs and ETFs that seek to maximise dividend returns.
ETFs do not protect you from market volatility. In fact, ETFs mirror market volatility more so than any other investment. Equity markets historically have been the most volatile, but they have provided the best returns over the long term.
- The product. For example, you should understand the difference between a vanilla and an enhanced index-tracker ETF. A vanilla index-tracker is likely to perform better in a strong bull market.
- Volatility risk. If you are investing a lump sum, particularly in equity ETFs, phase in your money to smooth out volatility risk.
- Your strategy. Assess the performance of your portfolio regularly and, if necessary, rebalance your portfolio to ensure that you are sticking to your investment strategy.
- Advice. If you do not feel confident to compile a portfolio of ETFs on your own, obtain advice. The best place to find a qualified adviser is www.fpi.co.za. This is the website of the Financial Planning Institute, which accredits financial planners who have met tough qualification standards.
You can negotiate what you pay for advice. It is preferable to pay a fixed fee and not one that is based on a percentage of your assets, particularly if you administer (buy and sell) your portfolio yourself.
The big step forward for ETFs will be when they are available for long-term products, particularly retirement products, such as RAs (used by people who are saving for retirement) and Illas (used by people who are in retirement).
The big step forward depends on two factors:
- The availability of ETFs that cover the full range of asset classes and that are linked to both local and offshore indices. Currently, there are no money market ETFs and the rand-denominated offshore ETFs track only equity indices.
- All Lisps providing access to ETFs. Increasingly, RA funds are sold on Lisp administration platforms, as are all Illas, but few Lisps offer ETFs. The main reason is apparently that the trading systems are structured around unit trust funds, which can be sold as whole or as partial units, whereas ETFs are sold only as single units, because they are shares that trade on a stock exchange.
Brown says he is planning shortly to provide an RA that will allow for an underlying portfolio of ETFs; and as soon as the required underlying fixed-income ETFs are available, an Illa that uses ETFs will also be made available on the etfSA platform.
Hot on the heels of ETFs, another exchange traded security is waiting in the wings: exchange traded notes (ETNs).
ETNs are debt securities issued by a financial institution that are listed and traded on a stock exchange (secondary market). You can sell an ETN in the secondary market or hold it until maturity. The price is determined mainly by the performance of the selected index and the credit rating of the issuer.
The big advantage of ETNs is that they will enable individual investors to have greater access to the commodity markets.
ETNs are based on structured products, which have been available in South Africa since the 1990s. Structured products provide partial or full capital guarantees, as well as guaranteeing part, all or a multiple of the growth of a pre-selected index or a basket of indices. The guarantees are mainly provided by international banks, and the derivative markets are used extensively.
However, structured products have been the subject of considerable controversy. The problems with the products have included:
- Lack of disclosure. Structured products are very opaque about their costs, and the opportunity costs are also hidden in the product structure - for example, investors do not receive returns that include dividends.
Other downsides were initially not fully explained to investors. For example, when the rand was sliding rapidly, investors in structured products that were linked to foreign indices did not know that they received currency depreciation on the index returns only and not on their capital.
- Fixed investment terms. Initially, the terms were fixed for five years (maturities now include shorter periods). So if the index was down from its peak at maturity, an investor could not simply extend the term without incurring additional initial costs.
- Liquidity. It is virtually impossible to cash in the investments before maturity.
- Guarantees. Although there are no known defaults on the guarantees in South Africa, there were concerns in the early days of the global credit crisis that some of the international banks that provided the guarantees could default on them if governments had not propped up many of the affected banks.
Listing structured products as ETNs on the JSE will have many advantages for investors. These include:
- The listing requirements will ensure full transparency, particularly about costs and structures; and
- The products will be liquid, because you will be able to buy and sell ETNs whenever the JSE is open for trading. This means you will not be locked into maturity dates.
Nedeljkovic says his company has an aggressive programme for the listing of ETNs this year. Absa Capital will start by listing commodity-based ETNs that track several precious metals and a broad commodity index. The listing of other commodity-linked products will depend on investor demand.
Nedeljkovic says ETNs will not necessarily be Cisca funds. The main difference between ETNs and ETFs is that ETFs are backed by a portfolio of actual assets held in a trust or a special purpose vehicle issuer company, whereas ETNs are issued by a bank and are backed (guaranteed) by the bank's balance sheet.
The reason ETNs are issued at all is that it is sometimes not possible for the issuer to hedge the index exposure in the physical spot market (a good example are broad commodity indices that track multiple commodities, including timber, livestock and oil), as would be required of an ETF. Also, Cisca's regulations are restrictive with regard to the assets that can be held by a unit trust fund or an ETF.
The ETNs that Absa Capital intends to list are a specific category of exchange traded products that are long-dated (ordinarily, a maturity of 10 to 30 years), index-tracking and non-capital-guaranteed (sometimes they are called delta one products, because there is no leverage in products of this nature).
Nedeljkovic says that for all intents and purposes, ETNs behave exactly the same as ETFs but are bank-issued and carry issuer credit risk.
ETNs allow far more flexibility regarding the types of indices that could be tracked; the transparency is ensured by the fact that they track publicly available indices with weightings published daily.
Similar to ETFs, ETNs have a market maker that ensures liquidity. Because they allow creations/ redemptions of blocks of securities in the primary market (in other words, anybody can exchange the block of securities for the cash equivalent to the ruling value plus a specified spread), and because of the presence of the market maker, the secondary market (the JSE) prices of the ETNs always closely track the underlying index value - again the same as with ETFs, Nedeljkovic says.
Click here for a table that summarises the differences between ETNs and ETFs.
An index is a measure of the performance of a market or a market sector. An index replicates the different shares in the market, mainly according to their value. In simple terms, if company A represents 10 percent of the value of a sector of a market, it will make up 10 percent of the index for that sector. By watching an index, you can see if a market or a market sector is rising or falling. The best-known local index is the FTSE/JSE All Share index (Alsi).
The market capitalisation (or market cap) of a company is the number of its shares in issue multiplied by the value of the share. The market capitalisation of a market sector is the aggregate of the market capitalisations of all the companies in that sector.
According to online encyclopaedia Wikipedia, the term benchmark originates from the chiselled horizontal marks made by surveyors, into which an angle-iron could be placed to bracket (bench) a levelling rod, thus ensuring that the levelling rod could be repositioned in exactly the same place in the future. In investing, a benchmark is used to assess the relative performance of an investment or a group of investments (for example, general equity unit trusts). The benchmark can be an index, such as the Alsi, an economic measure, such as the inflation rate, the price of a commodity, such as Brent crude oil for the petroleum price, or even the share price of a company, such as Berkshire Hathaway, which is controlled by investment guru Warren Buffett.
Actively managed investments are those where a fund manager seeks to out-perform a predetermined benchmark. In doing so, the fund manager will employ various investment techniques and use specialists to analyse companies, markets and the broader economy. Based on this information, fund managers actively trade investments to achieve the targeted out-performance.
These are funds where the fund managers do not apply any skill; they merely try to match the performance of an index. The fund manager buys shares in the same proportion as the index.
The exchange traded funds (ETFs) available on December 1, 2009 in alphabetical order of the product providers were:
Absa Capital has the advantage of being linked with British-based bank Barclays, which is one of the biggest providers of ETFs internationally.
Absa Capital has joined forces with a black economic empowerment (BEE) asset management company, Vunani Capital, to create a joint venture, NewFunds Collective Investment Schemes, which will issue all Absa Capital's ETFs in future. Already in NewFunds are the enhanced performance eRafi ETFs that are marketed in association with Plexus Asset Management, the Cape Town-based specialist unit trust fund company.
Vladimir Nedeljkovic, who is in charge of ETFs and index products at Absa Capital, says NewFunds is evaluating the most efficient way to introduce money market and bond ETFs to its product offering.
NewFunds is also considering creating additional ethical investment products following the launch of its Shari'ah Top 40 ETF.
Absa Capital's range of funds are:
- NewGold, which has attracted more money than any other local ETF, is a non-interest-based product that invests in gold bullion. In other words, the ETF directly tracks the fortunes of gold. The ETF is not and cannot be registered as a collective investment scheme, as it invests in bullion as opposed to listed gold-mining companies.
- NewRand follows an index (New Rand) devised by Absa Capital and calculated using the FTSE/JSE indices to follow the performance of the top 10 rand hedge stocks. A rand hedge company derives its income and profits mainly from offshore ventures and/or export earnings.
- NewSA, which tracks a modified index of the top 40 companies that provide investment opportunities in BEE.
- Shari'ah Top 40 is one of two ethical ETFs; the other is NewGold. It tracks the companies in the FTSE/JSE Top 40 index that meet the requirements of Islamic law.
- eRafi Overall is based on an enhancement of the FTSE/JSE All Share index.
- eRafi Financial 15 is based on an enhancement of FTSE/JSE Financial index.
- eRafi Industrial 25 is based on an enhancement of FTSE/JSE Industrial index.
- eRafi Resources 20 is based on an enhancement of FTSE/JSE Resources index.
Deutsche Bank is the only local ETF provider to offer offshore investment opportunities. Deutsche Bank is one of the world's major providers of ETFs, giving it international expertise and access. Its ETFs are rand-denominated: you invest in rands and receive your returns in rands in South Africa. Your once-off foreign investment allowance of R4 million is not affected by how much you invest in these ETFs. The ETFs are substantially the cheapest way for South African residents to access foreign investment markets. The db x-trackers are:
- db x-trackers FTSE 100 Index ETF, which tracks the top 100 companies listed on the London Stock Exchange;
- db x-trackers DJ Eurostoxx 500 Index ETF, which tracks the Dow Jones index of the top 50 blue-chip companies in the euro-zone;
- db x-trackers MSCI USA Index ETF, which follows the fortunes of the Morgan Stanley Composite index of 600 of the biggest companies in the United States;
- db x-trackers MSCI World Index ETF, which mirrors the MSCI index of 1 900 companies in the developed world; and
- db x-trackers MSCI Japan Index ETF, which tracks the MSCI's index of Japan's top 400 stocks.
The Zshares Govi is one of two fixed-income ETFs in South Africa. Investec's offering tracks the Bond Exchange of South Africa's Total Return Government Bond index (Govi).
The Property Index Tracker (Proptrax) ETF tracks the FTSE/JSE Listed Property index of the top 23 listed property shares and property loan stocks.
RMB has developed two Beta Investment Performance Securities (Bips) ETFs:
- Bips Top 40 ETF tracks the Top 40 index; and
- Bips Inflation-X ETF is a fixed-income ETF that tracks the Government Inflation-linked Bond index.
Satrix was the first company to sell ETFs in South Africa. All its ETFs are based locally, but joint chief executive Brett Landman says Satrix is looking at offering ETFs with international exposure. Satrix is also seeking approval from the Financial Services Board to offer ETFs in asset classes other than the equity range it has on offer. Satrix is now jointly owned by Sanlam and Deutsche Bank.
The Satrix ETFs are:
- Satrix 40. This ETF, which is the second most popular ETF among investors after NewGold, seeks to replicate the performance of the Top 40 index.
- Satrix Fini tracks the Financial index.
- Satrix Indi tracks the Industrial index.
- Satrix Resi tracks the Resources index.
- Satrix Swix Top 40 is based on the FTSE/JSE Swix index, which adjusts the Top 40 index. The Swix index down-weights (reduces the proportional percentage) shares in the Top 40 that are held by non-South African shareholders. This has the effect of reducing the net weightings of resources and dual-listed stocks and of increasing the weightings of financial, industrial and telecommunications shares, relative to the Top 40 index. The Swix index is regarded by asset managers and institutional investment advisers as the primary benchmark for the performance of the local equity market.
- Satrix Rafi is based on an enhancement of the Top 40 index.
- Satrix Divi tracks the FTSE/JSE Dividend Plus index. This index selects the best 30 dividend-paying companies from the top 100 large- and mid-cap companies on the JSE. The companies are weighted in the index according to their forecast dividend yield. The Satrix Divi appeals to investors who want both a yield (dividends are declared quarterly) and capital growth.
This article was first published in Personal Finance magazine, 1st Quarter 2010.