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A beginner's guide to ETFs

Jan 26 2017 14:02
Simon Brown

Exchange-traded funds (ETFs) have seen a massive increase in both interest and investment rands over the past few years, especially since the introduction of tax-free investing in March 2015.

I am firmly of the view that this is a good thing and the majority of investors should just buy ETFs, with the first R30 000 every year going into a tax-free ETF account. This will create wealth over time. It’s that simple.
But there are still two key issues that often confuse ETF investors.

Liquidity

The first is concern about liquidity; the amount of value being traded on investors’ ETFs. Often the liquidity is low (or at times zero) and investors are concerned about whether they would be able to buy and, more importantly, sell with ease. The answer is that they can.

ETFs all have market makers – a third party that is consistently in the market buying and selling the ETF either side of fair value. So, if the fair value of an ETF is 4 400c, the market maker would be a buyer at 4 390c and a seller at 4 410c. That 10c either side would be for costs and profits. 

Then, as the fair value changes, the market maker will adjust their buying and selling prices accordingly, which ensures liquidity either side of fair value. This means that even if trade volumes are low, all ETFs have potential to trade in volume as required and you can usually see the market maker as they sit on the buy and sell with round volumes. If you want more than they are selling, put your buy order into the market at the price and they will sell you the full allocation in lots.

An important point here is that other private investors can also be sitting on the buy and sell side and often inside the market maker. For example, using the above values, I may be buying the ETF at 4 398c while the market maker is only at 4 390c, and you would sell to me ahead of the market maker, which would bag you a slightly better price.

Delisting

The other concern that many ETF investors and traders have is the occasional Sens announcements announcing the delisting of an ETF. An example would be “Delisting of 200 000 XXXETF securities”. This nearly always sees my inbox filling up as people panic because they are under the impression that their ETF is being delisted and will ultimately be deleted. But this is not actually what happens.

An ETF is different to a unit trust with the latter creating new units, or deleting units, as and when they need. An ETF starts off by creating a pool of ETFs of, say, 1m. But if demand grows, they need more and will add an additional 500 000 (or however many) as needed and will issue a Sens announcing this.

Sometimes a large seller (or just decreasing popularity) could see a lot of the ETFs being sold back to the issuer so that they have an overly large number in issue. They may then elect to delist some and will issue a Sens to that effect.

It does not mean the ETF is being delisted, it just means there will be fewer in circulation. However, if demand increases again, more can be issued and as ETFs trade at fair value, the number available does not impact price.

A last point is that an ETF can in most cases be exchanged for the basket of underlying shares. If you contact the issuer with your 1m ETFs and request that they take back the ETFs and issue you with the shares that make up those 1m ETFs, they will oblige. But this is moot for most of us as we don’t hold that number of ETFs.

This article originally appeared in the 2 February edition of finweek. Buy and download the magazine here.

investing  |  etf
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