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The rise of the ETF

Sep 14 2017 08:22
Marcia Klein

With the growing trend for investors to move away from active managers, more and more money is flowing into exchange-traded funds (ETFs), one of the most popular passive investment vehicles.
   
ETFs are securities that trade on the stock exchange and track an index, commodity or bonds. 

ETFs trade like shares and can be bought and sold easily at fractions of the price of the underlying investments.
   
Investors have choice in terms of whether they want an index that follows the market as a whole or particular sectors or particular commodities, and can choose between local or offshore ETFs.
   
With the first ETF launched in Toronto in 1990, in the US in 1993, and in South Africa in 2000, ETFs are a relatively new financial instrument, but an increasingly popular one. 

There are now around 7 000 ETFs globally, while in SA there are 56 ETFs and 21 exchange-traded notes, or ETNs.
 
In fact, ETFs have grown in popularity to the extent that they have recently caused some concern, with the Financial Times (FT) saying ETFs are “eating the stock market”, accounting for more than 20% of volume on US markets. 

According to the FT, seven of the 10 most actively traded securities on US stock markets last year were ETFs – not shares.

CNBC quoted Elliott Management’s Paul Singer going as far as to say that the move to passive investing is “destructive to the growth-creating and consensus-building prospects of free market capitalism”. 

According to CNBC, “ETFs globally now have $1tr more in assets than hedge funds”, while about $2.2tr of assets are indexed to the S&P 500.
  
In fact, there is now an ETF, the Toroso ETF Industry Index, launched by US investment company Toroso Investments, which tracks the growth in the ETF industry by tracking companies that derive revenue from the ETF ecosystem, making it possible to buy an ETF linked to the success of the ETF industry itself.
  
The growth in popularity of ETFs arises from a growing realisation that very few active managers are able to pick stocks that continue to outperform the market. 

ETFs are one of the easiest ways to invest in index trackers, and are cheaper than many other investments, particularly those that are actively managed.
  
SA has been relatively slow to reach the kind of volumes one sees in the US, partly because of its late start and more gradual acceptance of ETFs as an investment vehicle, but also because South African investors have traditionally preferred dealing with active managers.
   
Younger investors, however, are more keen to make their own investment decisions, and ETFs offer a relatively cheap entry into index-tracking funds.
 
ETF investment in South Africa
 
Yet, ETFs are making their mark in SA. The market cap of ETFs reached R80bn at the end of June, says Mike Brown, CEO of etfSA. 

“There has been a nice increase in the size of the industry, trading volumes have picked up substantially, and there have been new participants coming in like Cloud Atlas and others, while Sygnia bought Deutsche Bank’s South African ETF business earlier this year. 

Satrix has brought out five new ETFs and there are quite a few other listings by ETF providers, so activity is picking up substantially.
 
“There is a general feeling across the investment community that passive investments have a role to play, and they tend to outperform 80% to 85% of active managers. 

People are saying that in difficult markets cost containment, flexibility and transparency are more valued by investors,” Brown says.
 
Galileo Capital’s head of wealth management, Yolande Botha, says investor interest in ETFs has increased substantially, although the uptake in SA is not as noticeable as in the US. 

“As a percentage of the market it is very small and active managers still have the bulk of investment capital.”  

People are talking more about the costs, leading to more interest in ETFs, but active managers have dropped fees too, she says.

Why ETFs?

ETFs are gaining popularity, but it is important for investors to realise there are a range of ETFs and their success depends entirely on the underlying investment.
 
“ETFs are simply investment instruments, and performance depends on which ETF you buy,” says Ashburton Investments portfolio manager Wayne McCurrie. 

“ETF is not a separate asset class like equity or property or a share – an ETF simply tracks a commodity price or index, it is just a vehicle to effect an investment choice.”
  
That said, the big advantage with ETFs is that they are cheap, “and they give you exactly what they say they are going to give – they track an index or a price. 

An active manager, on the other hand, is making decisions on your behalf and this costs more. 

They may or may not be successful, although the decision to buy the ETF may be wrong too.”   

An ETF is not the only instrument for tracking indices or prices. Unit trusts do exactly the same thing. ETFs, however, allow the investor to buy and sell easily and should be cheaper.
  
Investing in ETFs does not, however, make any investment decisions for you. 

“With an ETF, you, or your adviser or financial planner, still have to make an overall decision of where your assets should be and your risk profile, and the secondary decision is how to invest, and an ETF is one of the investment options,” McCurrie explains.
 
ETFs versus other passive investments
 
The main benefit of an ETF over other passive forms of investments is that they can be traded like shares, says Botha.
 
Ben Meyer, head of Sygnia Itrix, says ETFs offer flexibility as one gets exposure to a large diversified basket of underlying shares with one single trade: 

“There is a lower settlement cost per trade as one trade settlement compares to the settlement cost of potentially more than 1 500 shares, as in the case of the MSCI World index.”  

ETFs offer intra-day trading compared to unit trusts that settle once a day.

Satrix explains on its website that in the case of both unit trusts and ETFs, the investor essentially owns a “proportionate share” of the underlying investments held by the fund. 

“With unit trusts, the investor holds participatory units issued by the fund, while in the case of an ETF, the participatory interest comprises a security or share listed and traded on a stock exchange.”
 
There are many more unit trusts than ETFs, so they offer more choice. SA is quite well represented with ETFs, considering that it is a fairly small market, says Brown. 

“There is room for some more, but it is never going to be as big in terms of number of products as unit trusts, of which there are about 1 300.”
   
But ETFs allow the retail investor “to access the same exposure as institutions as ETF trade sizes are much smaller than the underlying basket size, so you can therefore access broad diversified exposure with a small investment,” says Meyer.
  
“ETFs are for everyone’s portfolios, including institutional investors, as the international experience shows.”
  
ETFs can sit in any portfolio, says Botha. 

They are for investors starting out and for experienced and wealthy clients. Many clients, she says, are happy to get the market return and so investing in ETFs or index funds is sufficient for many investors. 

Those with significant amounts to invest – say R1m or more – should diversify.  

ETF performance 

But investors do not necessarily get the market return. 

While commentators say ETFs simply track the index or price they are following, there can be significant differences in the performance of various ETFs that are essentially following the same entity.
 
The performance of ETFs should be directly correlated to the performance of the index or bond or commodity it is invested in.
   
Yet, surprisingly, if one looks at performance tables provided by etfSA to the end of July, there are, for example, seven ETFs that track the JSE Top40 Index, which recorded a 9.42% increase in total returns in the year to end July, yet the performance of the ETFs varies from -4.35% to 9.13%. 
  
The Stanlib Top40, at 9.13%, performed the best while the Satrix 40 was up 8.94%, Ashburton Top40 8.96%, Stanlib Swix Top40 5.37%, Satrix Swix Top40 5.14%, NewFunds Swix Top40 4.94% and CoreShares Equally Weighted Top40 –4.35%.
   
This partly reflects weighting – as one can see from the CoreShares performance, where Top40 shares are equally weighted and the two Satrix options, where Swix essentially gives a lower weighting to resources than the non-Swix option. 
 
The varied performance also reflects the importance of costs and fees. 

Brown says costs play a role in performance, “but there could also be some issues in terms of efficiency”, he says.
   
Investors should definitely compare fees, as well as the exact nature of underlying investments, before putting their money into ETFs. 

As these figures show, not all Top40 trackers are the same.

The performance of ETFs offering offshore exposure is also dependent on exchange rates, so the performance can vary markedly from that of the underlying investment. 
 
The major reason for investing in offshore ETFs is for offshore exposure. Meyer says investors can buy the Sygnia Itrix ETFs on the JSE, for example, without the need to get a tax clearance certificate or do a lot of paperwork. 

“The trade is in rand and through the ETF structure the funds are externalised using a much more cost-efficient exchange rate than investors can get from their banks.”
 
Robo-advice and AI investing 

There are a number of investment trends which point to increased interest in ETFs.
 
Chief among these is robo-advice and AI (artificial intelligence) investing, as these are likely to generate ETFs as a good option after assessing costs.
 
Botha says robo-advice has not had the uptake everyone thought it would as yet, but as banks and investment groups launch robo-advisers, the uptake of ETF-based investments should be big as they are an easier and more cost-effective way of investing.
 
Meyer says that “it is quite simple for robo-advisers to calculate optimal portfolios utilising ETFs as the underlying building blocks for investors, as ETFs give simple low-cost exposure to the various asset classes required, and can be purchased on an exchange in relatively small quantities."

“AI investing includes the use of various algorithms to achieve a specific trading output,” says Meyer. 

“ETFs facilitate the ability of these algorithms to allocate trades to sector-specific investments through the trading of one or more ETFs, which will give the broader exposure required. Ever-present market-makers in the ETFs ensure that trades can be executed timeously.”

While it is in its infancy in SA, ETFs seem to be the preferred option for robo-advisers globally as they are simple to understand and give investors immediate access to certain asset classes, says Brown.

Not for everyone 

Whether they will become the preferred option for investors remains to be seen.
 
Berkshire Hathaway’s CEO Warren Buffett has said: “The goal of the non-professional should not be to pick winners – neither he nor his ‘helpers’ can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 Index fund will achieve this goal.”

This may be good news for the ETF industry and may be true for US investors.
 
Laurie Wiid, director at NFB Financial Services Group, says investors should bear in mind that ETFs, particularly globally, have a different application to those available locally, which are skewed to a few counters.
 
“For example, a local Top40 tracker fund will be dependent on the performance of Naspers*, which accounts for a large percentage of the index,” he says.
 
“This means you can do exceptionally well or badly depending on the counters in the ETF.”
 
Globally, an index-tracking ETF could be tracking 500 shares instead of the 40 in South Africa’s Top40 Index, where one share (Naspers) dominates.
 
“We still believe in active management as there is a good selection of active managers that do outperform and can still tilt a portfolio in favour of performing counters, which is very different to an index tracker,” Wiid says.
 
Active managers can also be defensive and active, depending on the circumstances, and optimise their portfolios accordingly.
 
“Passive investments do have a role in a portfolio and they do have a use,” he says, particularly if an investor is looking for exposure to a certain asset class, like property, for example, where they may not have specific knowledge or insight to make specific investments.
 
“With index investing you are forced to hold everything, good and bad. Active managers can identify better performers and track records speak volumes.”
 
A few percentage outperformance can make a huge difference, he says. “This warrants using active managers.”
 
Wiid says people now focus on the fee-saving and tend not to look at the outcome and performance. 
  
A large number of South African investors still put their faith in active managers and rely on their advisers to try to beat benchmarks. 

But ETFs are gaining ground. “There is much more awareness around ETFs and we are inundated with enquiries. The industry is starting to gain momentum, but we are a long way behind the active industry,” says Brown.

“Nevertheless, we seem to be inundated with enquiries – even among pension funds who never bothered with ETFs previously, we are seeing a rolling interest, which will translate into business being directed to passive investments.”
 
These are the early stages of a swing in momentum to passive investment.

*finweek is a publication of Media24, a subsidiary of Naspers.

This article was updated to reflect the accurate one-year total return of the Ashburton Top40 ETF as 8.96%, and not 7.43% as the data originally provided to finweek indicated.


This is a shortened version of the cover that originally appeared in the 7 September edition of finweek. Buy and download the magazine
here.

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