ETFs: A guide for investors

The passive investment industry has expanded from a market capitalisation of R11bn for exchange-traded products in 2005 to nearly R80bn recently and the number of products available increased from only eight in 2005 to 70 by the end of 2015, according to InvestSA.

The popularity of exchange-traded funds (ETFs) has grown considerably in recent years thanks to the lower costs and diversified portfolios of these products.

In recent times, active fund managers across all stock markets have struggled to outperform the total investment returns of their respective index benchmarks. Global surveys conducted by the rating services company Standard & Poor’s (S&P) show that 80% of active fund managers cannot outperform the markets.

But before we delve deeper into the virtues of ETFs, or passively managed funds, it’s important to know what exactly they are.

What is an ETF?

Simply put, ETFs are collective investment schemes that track the market passively. These products don’t try to outperform the market (also known as “gain alpha”) as opposed to actively managed unit trusts.

Investors who buy ETFs directly own shares in a specific security, while unit trust investors own specific assets in specific quantities in a particular unit trust fund.

Simon Brown, investment expert and founder of the investment platform Just One Lap, explains: “ETFs are a basket of shares, much like a unit trust, but rather than trying to buy ‘winners’ – stocks that will outperform the market – these funds simply buy the index they track.”

ETFs can track specific indices, such as the JSE All Share Index, or things like gold, the oil price, certain commodities and equities, says Matthew Chapman, analyst at NFB Asset Management.  

Although ETFs are passive funds there will be a fund or index manager of some sorts that compiles the stocks, says Chapman.

“However, the index manager’s sole goal is to replicate the index by looking at stocks in a sector that will give investors a return equivalent to the specific sector, rather than choosing a single stock.

“Exchange-traded fund managers will for example use Vodacom and MTN as a proxy for the telecoms sector and not buy every single small-cap telecoms company.”

According to a press release issued by the internet-based information and transaction website etfSA, the construction and calculation of indices that ETFs follow have become more efficient recently: “Technology is now driving index construction efficiencies. Indices are formula-driven and take analytical approaches to constructing indices.”

etfSA cites the NewFunds S&P GIVI Resources ETF as an example. “This fund, which was the top-performing fund in South Africa over the past six and 12 months respectively, uses an intrinsic valuation formula to select companies in the resource index, based on fundamental criteria, rather than pure price and size.”

ETFs for beginners

Exchange-traded funds allow investors to buy and sell stocks without having to go through a stockbroker. It is therefore a “do it yourself” investment approach, says Shaun van den Berg, technical analyst and head of client education at PSG Wealth.

“The investor’s approach depends on what they want to achieve – do they want growth or income; do they want to diversify an existing share portfolio?” he says.

However, there are a few important questions investors need to ask their financial advisers when considering investment in ETFs, Van den Berg says, such as:

• What ETFs are available and what are their investment objectives?
• How are these ETFs meeting my investment objectives?
• What are the risks and what are the costs?
• Based on my risk profile, financial objectives and investment time horizon, what ETFs would you recommend and why?
• How do you suggest we structure my ETF portfolio?
• What are the tax implications if I decide to sell my ETFs?
  

Simon Brown, investment expert and founder of Just One Lap, suggests investors ask the following:

• What are the costs?
• What are the ETFs tracking?
• How do I make sure I’m not duplicating sectors when buying different ETFs?
  

Nerina Visser, ETF strategist and adviser at etfSA, has the following tips for those seeking to invest in ETFs:

• Determine your investment horizon: do you want to save or do you want to invest? There is a difference – equities give higher returns, but only over the long term (at least three years).
• Start with an ETF that gives you exposure to a broad spectrum of equities on the JSE. If you can afford to invest in more than one ETF, you can also buy an ETF with broad international equity exposure and ETFs that track listed property.
• Invest monthly, reinvest your dividends and do not fiddle unnecessarily with your investment.

This is an except from an article that originally appeared in the 12 May 2016 edition of finweek. Buy and download the magazine here.