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FULL STORY: 10things.etfs
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10things.etfs
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Personal Finance
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15 October 2010
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Bruce Cameron
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 & Poors (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:
1. What is an ETF?
ETFs are passively managed investments that are a hybrid of collective investment schemes
(CISs) and listed investment companies that invest in other companies.
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 underperform 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.
3.What are the costs?
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.
4. Why should you own an ETF?
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 outperform 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 underperform consistently.
The problem for many investors is how to spot the asset manager who will provide outperformance 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 outperforming 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.
Wesselss 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 ones 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 Plexuss 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.
5. How secure is an ETF?
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.
6. What taxes do you pay?
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.
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 banks 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, Ciscas 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-capitalguaranteed (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.
What the terms mean
Index: 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).
Market capitalisation: 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.
Benchmark: 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.
Active management: 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.
Passive management: 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.
Bips Inflation-X ETF is a fixed-income ETF that tracks the Government Inflation-linked Bond
index.
Satrix 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 dividendpaying 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.