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Why you should love ETFs

Everybody knows I am a huge fan of exchange-traded funds (ETFs), having bought my first one way back in December 2000, just a month after Satrix introduced the concept to South Africa.

Since then I have bought more every month via debit order, also adding more on an ad hoc basis and using ETFs to max out my tax-free investment accounts each of the last two years. 

But are they totally risk free?

First, let’s deal with market risk. If your ETF is heading south or sideways because the market is doing the same, well, then it is doing exactly as advertised and shouldn’t worry you at all.

Markets will go down, they will go sideways, but mostly they will move higher and an ETF portfolio will diligently follow the market. 

However, we do have busted ETFs and risk of the ETF issuer perhaps going out of business. What happens then? 

If the issuer goes bust

In the case of the issuer going bust, an ETF holds the underlying assets (shares or commodity) and we’ll be just fine.

The shares or commodity will be sitting in a separate vehicle and we’ll still have our ownership. Concerns over Deutsche Bank (DB) for example going bust are to my mind overdone, but even if the worst does happen, your DB x-trackers will be fine.

But if you hold an exchange-traded note (ETN), then the story is different.

An ETN is essentially a credit note promising the return and if the issuer goes bust, that promise becomes worthless and you join the queue waiting for your money back. So an ETN does carry some extra risk; it may not be absolute but it is real. 

In the South African case Absa, Standard Bank and Deutsche Bank issue ETNs and while I hold no ETNs, this is not because I am concerned about the risks, but rather that none of them have been attractive to me.

If you are worried that Deutsche Bank could collapse (as I said I am not), then exit their ETNs. 

Ineffective methodology

The other issue is a busted methodology for an ETF and here the Satrix Divi (STXDIV*) comes into play. I have held this since listing in August 2007. The return has been miserable and the dividend yield has been all right – but just all right. 

This was SA’s first smart beta ETF and the methodology was to buy stocks that had a high forward dividend yield (DY).

I liked the idea as it offered dividend yield, but also in a way it was a contrarian play as often the stocks included would be those dividend payers that had been beaten down, hence rising the dividend yield. So you got dividends for a while, then the stock price would rise and you’d get that increase as well, before the forward DY dropped and they were excluded from the ETF. 

The problem was simple and highlighted in recent years and I’ll use just two examples, African Bank and Kumba. Both had massive forward dividend yields as they’d paid chunky dividends and the price had fallen. The problem was that the dividends got cancelled and the price kept on falling. So we got a double hit within the ETF.

At the end of the day this is a busted methodology and I will be selling mine as soon as this issue hits the stands. The bigger question is whether smart beta is as smart as we are promised by the smart people designing them. It’s an important consideration and I will delve into this another day.

*The writer owns STXDIV.

This article originally appeared in the 11 August edition of finweek. Buy and download the magazine here.

 

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